Malcolm Graham
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Malcolm Graham in Trading psychology,

Fall melt up means rate move in December

The chorus is growing louder for the Federal Reserve to finally raise rates, as volatility eases and markets yet again push to new highs. Is it a coincidence that the Fed held off on hiking rates following the ugly third quarter in stocks? Probably not given what appears to be an extreme sensitivity to equity prices as a driver of monetary policy.

Time and time again, any blip lower in U.S. equities seems to result in some Fed official coming out with dovish comments which remind investors that liquidity is ample and will not stop. Time and time again, any move higher in stocks appears to increase the odds of a rate hike in the Fed's next meeting based on the futures market.

"Moving on is a simple thing; what it leaves behind is hard."
—Dave Mustaine

I believe there is a good chance the Fed will hike rates in December, but only if oil stabilizes and the Fall Melt Up I argued was likely last month moves toward cyclical sectors and emerging markets. So far, the rally has been largely centered on large-cap liquid names.

The next stage likely needs to be driven by higher-beta growth names which have largely underperformed since June. Bulls like to see small-cap growth names doing better than large caps, as it implies markets are betting on a healthier economy.

Small-cap stocks have tended to be more tied to domestic growth and inflation expectations than multinational large-caps. The combination of small-cap strength combined with an emerging market run, both of which our alternative ATAC Inflation Rotation Fund ATACX, -1.08% can rotate into, I believe would likely give the Fed enough confidence to finally raise rates.

Such a scenario looks very plausible in my opinion. Take a look below at the price ratio of the iShares Russell 2000 Growth ETF IWO, -0.91% relative to the iShares Russell 1000 Growth ET IWF, -0.34% . As a reminder a rising price ratio means the numerator/IWO is outperforming (up more/down less) the denominator/IWF. A falling ratio means the opposite.

Note on the far right that the ratio looks like it may be set to reverse after nearing the October 2014 low, and is quite far away from its 2013 peak. If small caps can resume the leadership role in terms of outperforming large caps, it would indicate growing confidence that a broader-based and sustainable move would occur in equities. This, in turn, should coincide with a pick up in inflation expectations which are important to consider as shown in the summary versions of our award winning papers (click here to download).

Outperforming small caps, rising bond yields, ongoing credit-spread tightening, and underperforming utilities are quite the recipe.

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Michael A. Gayed, CFA is the co-Portfolio Manager of the Overall Morningstar 4 Star rated ATAC Inflation Rotation Fund (Ticker: ATACX, rating as of 9/30/15 among 234 Tactical Allocation Funds derived from a weighted average of the fund's 3-year risk-adjusted return measures).

Opinions expressed are those of the author and are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

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