The Bear Paradox of 2012?

Michael Gayed, chief investment strategist at Pension Partners, LLC., reports in MarketWatch on the Bear Paradox and the negative narrative:

Okay so here we are with weak jobs data, market internals which remain tilted towards the downside, continued concern over Spain, fear of a repeat of the Summer Crash of 2011, etc. Yet, the Dow Jones Industrial Average remains glued to the 13,000 level so far, the Nasdaq remains near the 3,000 level, the S&P 500 remains close to 1,400, and bond yields in the U.S. and in Germany are pushing new panic low levels.

Many are beginning to get very bearish on stocks (just take a look at fund flows out of equities and into bonds and recent AAII sentiment surveys for proof), with that whole "Sell in May and Go Away" mantra being said fairly frequently in the media.

However, there is a "Bear Paradox" happening now.

The negative narrative has been so beautifully constructed, that it seems like everyone understands what's happening in global financial markets. Studies show that when you explain something to someone, that person tends to overestimate the odds of that thing you're explaining happening.

Note that this was one of the reasons I argued for a "Fall Melt-Up" right before the October low of last year (see one of my very first media interviews at http://online.wsj.com/video/7D28B8FC-4F75-453F-8B67-00892721BD97.html and please disregard my terrible haircut that day). From a pure psychology standpoint, because the negative narrative is so easily understood, we are all likely overestimating the odds that the story plays out as we expect.

So what is the Bear Paradox? Very simply if you believe that a deep correction is coming, then you are assuming that another "flight to safety" trade is on the way. This, in turn, means bond yields likely drop even further. But they are already at panic low levels.

So let's play the thought process out. Stocks decline hard, money goes into "safe" bonds, and bond yields drop further below the Fed's inflation target of 2%. Meanwhile, as stock are falling, their dividend yield goes up in absolute turns marginally, and in a big way relative to Treasuries.

This is the key difference between now and June of last year when I began calling for a Summer Crash - absolute yield levels now do matter which is one other reason for my "Spring Switch" thesis of money coming out of bonds and into stocks.

The Bear Paradox can be explained through the bond/stock ratio. Take a look below at the price ratio of the iShares Treasury Bond 7-10 Year Bond ETF relative to the Dow Jones Industrial Average. As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/DIA. For a larger chart, visit http://pensionpartners.com/marketwatch/iefdia050412large.JPG

I have been noting since early April that a mini-correction was likely, as bonds began outperforming stocks on weak jobs data. The trend has been painfully slow on the upside as stocks recovered fairly quickly off of mini-correction lows hit in mid-April.

Now, one could argue that the trend is just getting started on the way up. The problem, once again, is that absolute yields are painfully low, particularly given inflation. As stocks go down while bond yields are this low, it only makes equities comparatively more attractive.

I continue to believe this is a year of reflation, and market action in the next few weeks should provide clarity on which way the ratio is likely to go.

In another article, Michael Gayed wrote that energy will lead in a 2012 reflation:

Strong ISM data, continued reflation, and the "Spring Switch" (the idea of a "Great Re-Allocation" out of bonds and into stocks), following the Summer Crash, Fall Melt-Up, and Winter Resolution, continues to bolster risk assets. We may be nearing the next major leg higher for stocks.

Despite all of the "Sell in May, Go Away" calls, if I am right that the environment is similar to 2003 and 2009, the contrarian trade remains one of betting on a continuation of time in the uptrend.

I have stated in numerous interviews that emerging markets will likely continue to push reflation into the global financial system as Brazil, India, and Australia all take on more aggressive monetary easing. Who needs QE3 when money printing by SuperBen and the League of Extraordinary Bankers are forcing scared money into risk assets?

Rising collateral is what QE is all about — which means a rising stock market is QE3 as I have stated in my writings before. Our own ATAC models are nearing a full "risk-on" signal with a bit more confirmation needed before going full on back into stocks. If the signals are correct, and inflation expectations continue to march higher, I think the next rotational leader will likely be the Energy sector as I noted on Bloomberg live in a segment which can be seen at www.youtube.com/pensionpartners .

Take a look below at the price ratio of the Energy Select Sector SPDR ETF XLE relative to the S&P 500 IVV . As a reminder, a rising price ratio means the numerator/XLE is outperforming (up more/down less) the denominator.

I've annotated the chart to show various periods of strength and weakness in the Energy sector relative to the broader S&P 500. Notice that Energy peaked out around March of 2011 as the deflation pulse I first wrote about for Marc Faber of the Gloom Boom and Doom Report in February 2011 began beating. Since then, the ratio has effectively collapsed, sending it to levels not seen since mid 2010 (the "Ratio Support" line).

If reflation is real, and the global growth story comes back because of monetary stimulus from emerging markets (with China likely to follow), I suspect a big move back into resource stocks could occur and help drive markets to new all-time highs.

Interestingly this would likely not be "fear driven" because of a potential military conflict with Iran (which seems like a smaller probability now), but appears to be coinciding with the "Spring Switch" as retail money begins to question the negative narrative, and re-allocate into stocks.

When was the last time stocks were loved anyway?

Stocks are not loved because investors gripped with fear over developments in Europe and elsewhere, are playing it safe, scaling back risk and waiting to see what will happen. But as I've already written, the stay-liquid-and-wait approach is not wise as top funds are buying the dips and going on "RISK ON" mode.

And Michael Gayed is right, energy will lead the 2012 reflation as the global game changer is well underway. I remain long natural gas, oil and oil servicing companies as well as pipelines. I also think that beaten down coal and alternative energy shares deserve a closer look at these levels. Of course, financials, tech and homebuilders remain favorites among top funds and this will become clear once 13-F filings go public in a couple of weeks.

Below, Michael Gayed talks about the outlook for the U.S. stock market. He speaks with Pimm Fox on Bloomberg Television's "Taking Stock" (April 27th, 2012).