Needing a correction, or just wanting one? «
Stocks have been somewhat volatile as markets kick of 2014 trying to figure out what happens next to the economy and Federal Reserve policy, which raises the question of whether or not that volatility is a sign of a potential correction in the making, or the fact that some market participants would prefer one, regardless of conditions.
Emerging markets — represented here by the iShares MSCI Emerging Markets ETF /quotes/zigman/322623/delayed/quotes/nls/eem EEM -1.19% — looked like they were in the midst of another severe drop until Friday’s gain reversed five straight days of weakness. U.S. small-cap stocks, as seen through the iShares Russell 2000 ETF /quotes/zigman/260873/delayed/quotes/nls/iwm IWM +0.13% , despite being extended, are now positive year-to-date while multinational large-caps remain slightly lower. The most powerful mover thus far has, surprise surprise, ended up being longer-duration Treasurys, repped by the iShares 20+ Year Treasury Bond ETF /quotes/zigman/1480195/delayed/quotes/nls/tlt TLT +0.01% , which staged a huge rally on the heels of Friday’s weak payroll report.
Yes, inflation expectations have been rising since early December, but if economic data and earnings come in very soft in the weeks ahead, that could change reflation convergence sharply. As I have noted continuously last year, there is a huge gap between what stocks think about the future, and inflation expectations which vastly disagree. Some of the gap may be due to quantitative easing itself, which the marketplace based on inter-market trend analysis seems to suggest was a source of disinflationary pressure and counter to the Federal Reserve’s stated goal.
“Where sense is wanting, everything is wanting.”
If the payroll report is a harbinger of bad things to come, then yields may begin to fall and surprise once again despite the continued meme of a rising rate environment. But how can rates fall when the Federal Reserve just tapered and has committed itself to exiting quantitative easing? The market must do the Federal Reserve’s job by dropping rates down again. Should this be the case, it’s worth considering that a risk-off period similar to those experienced in nearly every year except last year is soon to come. What would define a risk-off period? Collapsing yields and stocks.
This may be a very real scenario, though it seems more likely that long-duration bonds could do well, U.S. stocks could flatline, and emerging markets could converge and perform given historical seasonality.
What is one way of gauging if a correction is soon to come? Take a look below at what I call the “need/want” price ratio which compares the Consumer Staples Select Sector ETF /quotes/zigman/246134/delayed/quotes/nls/xlp XLP +0.01% relative to the Consumer Discretionary Select Sector ETF /quotes/zigman/246177/delayed/quotes/nls/xly XLY +0.11% . As a reminder, a rising price ratio means the numerator/XLP is outperforming (up more/down less) the denominator/XLY. For a larger chart, please click here .
Because lower-beta consumer-staples stocks can provide clues on underlying sentiment shifts relative to higher-beta, more cyclical-discretionary stocks, the trend in the ratio can be indicative of whether stocks do well or have a hard time rallying in the near-term. Note how severely the ratio has been underperforming, and how vastly oversold it is.
While the trend higher has not yet asserted itself, we must ask the question of whether we are on the verge of a correction in either price (outright declines) or time (sideways movement). Inevitably, the ratio will reverse for some period of time, and that reversal may be coming soon given how long its weakened for the begin with.