"When the facts change, I change my mind. What do you do, sir?" - John Maynard Keynes
The S&P 500 (SPY) had a nice week as the Dow (DIA) continued to make new all-time highs. Stronger than expected jobs numbers helped push the unemployment rate down to 7.7%, a four year low. It appears that the Rocky Balboa stock market never left the ring, at least in the U.S. I had been arguing since the very end of January that odds were favoring a correction for stocks. Behaviorally, the same intermarket trends which warned of the Summer Crash of 2011 and mini-corrections of last year were acting like a correction was underway in terms of what was leading equity averages. Emerging markets (EEM) and Europe (VGK) wobbled, and it looked like a decline was about to aggressively take hold mid-February. I likened the environment to driving in a snowstorm - not a guarantee of an accident, but conditions that made one more likely.
There is no doubting it - the Nouveaux Bulls got this one right. Just as I had been pointing out the strength in bonds in what appeared to be a period of yield curve flattening, a stunning and sharp reversal began to take hold in everything that had made us negative on risk assets in about three days. It is as if the market were sensing better payroll data as the risk-off fever broke. Yes - the outcome was wrong, but I stand by the analysis. Our ATAC models used for managing our mutual fund and separate accounts were defensively positioned largely in bonds. That trade did well up until the tail end of last week. And while the speed of the move was surprising and unusual given how long the disconnects persisted, it still must be respected. We rotated out of bonds (TLT) fully into stocks on Friday.
It is unclear if this signal will hold given the sensitivity of our models. There have been times in the past where a move to one asset class is done one week, ultimately to result in a shift back to another the week after. We consider this very much a strength to the approach, as it allows for the potential to get in and out of risk asset quickly and smoothly. When it comes to trading, its okay to be wrong as long as you aren't very wrong for very long, and so long as your process is right. The conditions were there for a fall, but it appears that the Fed's $85 billion per month through QE averted a breakdown in U.S. stocks. If you notice how the Bloomberg European Financial Conditions Index behaved, there was something very clearly happening in February. Note the peak happened late January, right as the correction call was made. The setup was there, and it could have easily happened. The correction did not. Regardless of hindsight, we would much rather miss a 3% rally in the S&P 500 then a drop of 10% had the correction scenario played out.
There are now a few interesting scenarios that can play out now, given that one must always focus not on a past trade, but rather the future one. First, it is entirely possible that the breakdown in risk-off sentiment fails to hold, and a near-term top in stocks is in place. If this is the case, we likely would head right back into bonds. Ironically this would mean that the correction call wasn't wrong, but rather just early. This from a performance standpoint isn't a big negative for us because it would allow for a resync of the model to the market by helping us to potentially avoid the drop that we were preparing for over the past six weeks.
The other scenario is what I call "the fat pitch." Emerging markets have underperformed the S&P 500 by over 900 basis points year to date. That is significant weakness. If indeed we are in the midst of an economic acceleration, it is only a matter of time for emerging market stocks to lead once again, especially as QE money pour out of our borders in search of cheaper assets. If right, the coming move can be a substantial one for our mutual fund and separate accounts, making the last month and a half of underperformance a moot point. While we aren't there yet, I suspect we could make such a rotation next week if risk-on conditions hold.
Not every call will be right, and not every trade will be profitable. However, we know our process, we know the research, and we stand by our models. The key in this is to always adjust dynamically and let price dictate your actions. Intermarket price was warning of a correction, and it didn't happen this time. That does not whatsoever invalidate the caution we were taking on. The year is young.
Additional disclosure: This writing is for informational purposes only and does not 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.