“Every painting I do is related to the last one: it may be a continuation of a previous painting or it may be a reaction against it.”—William Scott

Over the last few weeks, I’ve been making the case that inter-market trends suggest we are in the midst of a “melt-up” driven by exactly the right kind of leaders, i.e. small-caps, cyclicals and emerging markets.

Just to rehash, in general, investors play bull markets by putting money to work in those areas of the investable landscape which are most sensitive to growth and inflation. Over the last few years, due to the “hunt for yield,” these areas of the market were not where money fled to, but rather fled from. This resulted in a distorted internal market that broad market averages have largely masked.

This is clearly changing, as an internal rotation away from defensive sectors toward those that “play more offense” takes place. Utilities are perhaps the poster child for this. As shown in the 2014 paper I co-authored (click here to download), the relative performance of utilities to the broader market, in the short-term, has historically been a leading indicator of volatility.

Utilities lead on a short-term basis? Volatility on average has risen.

Utilities under perform on a short-term basis? Volatility on average has fallen.

The price ratio below of the Utilities Select Sector SPDR ETF (XLU) relative to the SPDR S&P 500 ETF (SPY) shows a large sideways pattern in utilities relative to the market, with near-term momentum very much against the utilities sector. That downtrend looks set to continue, and that should be indicative of an ongoing calm environment in the near-term.

The potential for this ratio to push to 2015 lows is very real. What would take us there? An ongoing surge in emerging markets might do it. Some will say they have come too far, too fast.

Looking at emerging markets relative to the S&P 500, however, shows that the move is unbelievably small in the context of massive weakness over the last several years. Ongoing relative strength in emerging markets probably means it is hard for U.S. stocks really fall hard, supported by renewed overseas bullishness.

Bottom line? While there remains a lot of nervousness, there actually is a lot of potential for developed equities to grind higher, with ongoing outperformance in overseas markets. The shift away from yield plays to capital appreciating ones is a major theme which, should it continue, is likely to be quite bullish for active allocators. I, for one, am excited to see this kind of behavior — it’s been a while since stocks really behaved like a bull market was underway.