The most important question in the world

"Fear defeats more people than any other one thing in the world." -- Ralph Waldo Emerson

I co-hosted Bloomberg Rewind with my colleague Ed Dempsey on Monday ( click here) and a number of topics were covered, especially relating to Europe and the deflation pulse which has been beating ever since my April 6 article here on MarketWatch.

In that piece, I argued a mini-correction was likely. Early April was also around the time my company's ATAC (Accelerated Time And Capital) models we use for managing client accounts signaled that it was a better time to buy bonds than stocks, as we sold off the bulk of our equity positions and repositioned largely into Treasuries. I even had the honor of making the case alongside Gary Shilling on April 11 that a deflation pulse was beating.

I have since then consistently argued that this is the exact test for the "Spring Switch" thesis out of bonds and into stocks (the "Great Re-Allocation"), such that if the stock market was able to act resiliently in the face of the negative narrative, it only furthers the case for 2012 being a year of reflation similar to 2003 and 2009 within the context of a 40+% like move for equities (the Rocky Balboa analogy is appropriate here).

On April 23, in an article titled "Is the Mini-Correction Over?", I specifically said that "the mini-correction may not be over just yet." So far, despite world-wide equity averages having largely given back their gains made for the year, the "mini-correction" in the U.S. has played out as I believed it would given that we are (as of writing) roughly only 6% off the recovery highs of 2012.

Our ATAC models, which are run weekly and have the flexibility to go long bonds or long stocks depending on market conditions, remain negative given that some dramatic intermarket changes have occurred following elections in Europe. Bonds have performed strongly since April, but stocks in the U.S. have not declined in a panic way. The volatility characteristics are completely different now than they were in the midst of the Summer Crash of 2011.

I believe much of this has to do with the "bear paradox"�the more bearish you are on stocks, the more bullish you are on bonds in the face of panic-low Treasury yields that are far below the Fed's stated inflation target, and in the face of companies raising dividends making their yields comparatively more attractive than what can be found in "risk-free" government debt.

I very much stand by my initial analysis of how the conditions are playing themselves out, but there was a segment during Bloomberg Rewind which I want to address in honor of the much more bearish camp out there. The segment was titled "What's Keeping You Up At Night?"

What is the "nightmare scenario" that makes me most afraid? This can be answered with a simple question which I believe now is the most important question in the world: �Is the bond market right?"

Bond yields in the U.S., Germany, and a number of other countries are nearing all-time lows. Are these bond yields indicative of a weak economy and depressionary environment, or will it cause reflation to occur? The reason this question keeps me up at night is because the longer-term implications of the bond market being right means we are in a global depressionary environment, which in a highly leveraged world, likely means economic malaise transforms into societal upheaval. If the bond market is right, we all have much bigger things to worry about than what the Dow Jones Industrial Average DIA �is doing.

Yet, this very fear that I think is shared among many investors is precisely why 2012 could still play out like 2009. When the Dow was collapsing under 7,000, the same kind of "end of the world" message was being signaled by the stock market. At the time, I recall speaking to a knowledgeable investor about whether it was worth taking the risk to buy stocks. To me, it was a meaningless question because if the stock market was right back then, our money would all be worthless as the implication would be a collapse of the economic system.

My argument at the time was that you might as well bet that such a scenario won't happen, because if it did, we might as well all learn to farm and hunt in an effort to survive a very different world. This was within weeks of the March low.

A similar message is being expressed now, but this time in the bond market through these low yields. My mentality is very much the same now as it was in early 2009 before the March low�if the bond market is right and a collapse is coming, then we should all take lessons on how to survive outside of the economic and societal framework we are used to. Sure, we may be headed to that, but its not the way to bet because the implications go far beyond invested assets and more toward us as a people functioning together on this earth.

With yields this low, the bond market is indeed saying deflationary fears are growing. Take a look below at the SPDR Barclays TIPS ETF IPE relative to the nominal iShares Barclays 7-10 Year Treasury Bond Fund ETF IEF . As a reminder, a rising price ratio means the numerator/IPE is outperforming (up more/down less) the denominator/IEF. For a larger chart, visit http://www.pensionpartners.com/marketwatch/ipeief051512large.PNG.

An uptrend in the ratio means inflation expectations are rising, while a downtrend means a deflation pulse is beating. As you can tell on the far right of the chart, the ratio is heading lower, but doing so in the face of already panic low yielding absolute rate levels. Much of this is attributable to the post-European elections which have reawakened the bears. The implication is that the "mini-correction" environment is getting harsher.

I remain optimistic on the stock market for 2012 despite our ATAC models keeping our clients largely in bonds now, which has so far been the right move since April, all with the knowledge that our ATAC models are designed to quickly reallocate back into stocks as conditions improve.

However, should the deflation pulse beat faster and the trend in the ratio chart further break down, then we could be in for a much more serious scenario than anyone is prepared for. I simply don't believe this will happen�the negative narrative that is regurgitated today could also have been said in the lead-up to the Fall Melt-Up/October low of last year. That negative narrative could be entirely overestimated as I stated in an interview going over the idea at http://www.youtube.com/watch?v=17-TYGPawZY.

Time will tell if I am wrong of course, but if I am not, and it is indeed the bond market that is incorrect about the future, then the Spring Switch likely gets flipped after all.

This writing is for informational purposes only and doesn't constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.