The Melt-Up Set Up for the December to Remember

By Michael A. Gayed

On October 6 here on Minyanville I made the argument that markets were on the verge of a “Melt-Up” in the fall as market internals I track improved and signaled a sharp advance was to come (see The Most Powerful Reason to Believe in the Fall Melt-Up of 2011). October ended up being one of the best months for risk-assets in decades, as markets cheered what appeared to be a near-term solution to Greece. Then, last week, Italy's 10-year yields spiked to over 7%, promptly causing me to argue that Italy may have short-circuited further gains ahead. With Spain now a concern and Europe getting closer and closer to the edge of an “event,” I believe the Melt-Up is over unless there is some massive policy response to the crisis causing yields to drop sharply in Italy and Spain.

The U.S. Treasury bond market remains unconvinced with yields back around panic levels. Meanwhile, equities remain elevated. This is a significant disconnect which we have seen before this year in the lead up to the August/September Summer Crash. On the one hand, the bond market believes that inflation is pretty much dead and that the odds are increasing of a true deflationary spiral occurring worldwide. On the other hand, equities as proxied by the S&P 500 seem to be discounting a better economy going forward. Who is right?

Generally speaking, the bond market is a lot more right more often than the stock market. That doesn't mean it can't be wrong...it just means that in an IQ test between the bond market and the stock market, bonds generally tend to get the top score. The bond/stock disconnect needs to be resolved once again, and likely can be resolved in a similar way to the August/September declines in risk-assets. Take a look below at the price ratio of the iShares Barclays 7-10 Year Treasury Bond Fund ETF (IEF) relative to the S&P 500 ETF (IVV). As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/IVV.

Here is the takeaway: The price ratio was stuck in a range between mid-August up until a spike high of a little past 0.85 at the end of September, right before the October Melt-Up in equities occurred. Yields spiked as equities rallied, but then a curious thing happened. The ratio dropped but rebounded sharply in late October, and has since resumed strength, suggesting renewed outperformance in U.S. bonds relative to equities is taking hold. With yields already so low, if the trend persists, it likely occurs through the denominator (S&P 500) shrinking. And because stocks tends to act with a lag, the true expression of this may begin in a couple of weeks. We are set up for a December to remember, which may result in an environment similar to August/September of this year if the yield fever in Europe does not break.

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