"Amazement awaits us at every corner." - James Broughton
The S&P 500 (SPY) continued its advance, with Friday marking the end of the Dow's 10-day winning streak as economic data came in better than expected across the board. Retail sales were strong despite high gas prices, jobless claims continue to tick lower, and industrial production remains quite positive. It is clear that the reaction following last week's ADP report which I noted changed many intermarket trends and broke the correction case was not to be ignored. The streak of gains in the Dow (DIA) was the longest since 1996 - that alone should indicate how jobs data impacted equity risk sentiment.
As of Thursday, it looked ever more likely that risk-on sentiment would persist. I've been pointing out the severe underperformance in Emerging Market (EEM) stocks in my writings, making the case that they are the "next fat pitch" which could lift global sentiment should strength start to kick in on deeply oversold price behavior. On Friday, however, market internals turned surprisingly negative. Our ATAC models used for managing our mutual fund and separate accounts rotated out of stocks for the week right back into bonds, which is something I noted was a possibility the week prior. Something was bothering the market Friday by enough to trigger a switch for our strategies. At the time, it seemed that CPI and consumer sentiment data were the reason.
Turns out, it may have been Cyprus that caused Friday's deterioration. Late Friday, finance ministers put together a bailout package to keep banks from shutting down and prevent a full blown crisis. While Cyprus makes up a tiny portion of Europe's overall GDP, the issue relates to the conditionality of the bailout. As part of the deal, every depositor will have some of their money confiscated through a "levy" - 6.75% for accounts under 100,000 Euros, and 9.9% for accounts over that amount. Needless to say, this is a dangerous precedent as it means that savers who had nothing to do with the crisis are now paying for it directly from their own checking accounts. Banks are shut down, ATMs aren't working, and the government of Cyprus is doing whatever it can to prevent money from fleeing the country. This, folks, is how bank runs happen.
The risk is not about Cyprus itself. The risk is that at the margin Europeans in other countries seeing the situation unfold might decide to pull money out of their own banks for fear that a chunk of it could be taken to fund future bailouts of their own financial institutions. It is the precedent that is the problem, and I suspect the next few days will be important to keep an eye on in terms of market reaction. There is a chance the bailout deal does not get approved by Cyprus' parliament, which would further complicate things.
What amazes me is that somehow, intermarket behavior was expressing concern Friday. Somehow, price was sensing some kind of deflationary pulse again out of nowhere just as it seemed safe to continue to play the equity rally. Having said all that, it is highly unclear if the stock market will care about any of this. QE has served as a type of Novocain to global macro risks and shock. Intermarket trends are not yet entrenched enough to suggest near-term correction risks are back. Rather, at the margin this may simply put a bigger bid into bonds in the near-term as a relative safe-haven play, particularly by Europeans who may grow more and more concerned about their bank deposits.
This is about conditions and process. Our inflation rotation approach is designed to be nimble and rotate between stocks and bonds as conditions warrant through the behavior of intermarket trends and inflation expectations. The next couple of weeks will be telling if indeed this is the butterfly flapping its wings which can cause a hurricane, or if the Fed's QE will simply act as pesticide. Either way, we stand ready to accelerate time and capital spent in markets for our clients.
Of course, the great irony would be that just as it looked like the late-January correction call was "wrong" with hindsight, it ends up being re-classified as simply early…
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