"We all pine for a time in life when things were simpler. Even when they weren't necessarily simpler, hindsight makes them look a lot simpler. The reality of it was that it wasn't." - Ben Gibbard
It was a rather eventful week that was for worldwide markets. As I noted in various writings, several intermarket relationships dramatically reversed following the last payroll report which came in better than expected and showed upward revisions to prior month data. The S&P 500 (SPY) and the Dow (DIA) hit new highs with defensive, dividend sectors failing to participate, lagging in what is perhaps the first real healthy sign of internal market behavior since the deflation pulse began at the end of January. Bonds (TLT) fell hard and yields spiked in a remarkable way, with the 30 year Treasury back at 3.09% in the blink of an eye. Treasury Inflation Protected Securities relative to nominal bonds are holding support, in what now appears to be a sudden realization that the reflation trade is very oversold.
Make no mistake about what's happened so far this year - outlier behavior is all over the place. The Dow Jones Industrial Averages has not closed red for three days in a row year to date, something which has not happened since 1958. The rally up until recently was driven by low beta, high dividend, inelastic sectors while cyclical true growth plays failed to lead. Our ATAC models used for managing our mutual fund and separate accounts rotated out of bonds the Friday before last week, sidestepping the carnage in fixed income that followed right after. Now, with the yield curve wanting to steepen and signs of life in the cyclical trade, a more traditional "risk-on" environment seems to be at hand.
The gap between inflation targets and inflation expectations appears to be under attack now with the European Central Bank, Reserve Bank of India, Reserve Bank of Australia, and Bank of Korea all lowering rates to counteract slow growth and deflationary pressures. At the margin, this should benefit the cyclical trade as these measures more directly impact local economies, and stimulate activity. In theory, this should provide yet another reason for why emerging market stocks could play catch-up against U.S. averages after having badly lagged this year.
A piece came out Friday by the Wall Street Journal stating that Fed officials have begun mapping out an exit from Quantitative Easing. This seems to explain why bonds fell hard last week and the Dollar rallied as investors got wind of the idea prior to the article's writing. This could conceivably be bullish for stocks, as any hint of the Fed stepping away from Quantitative Easing might hasten those who have delayed borrowing to do so now rather than risk higher interest rates later. If the yield curve ends up steepening at a gradual pace then, equities likely become the beneficiary.
Having said all this, the key is that intermarket behavior remains persistently in favor of the reflation trade, given that disconnects are still very wide despite last week's improvement. Because our strategies are weekly in nature, we have no problem rotating back into bonds if conditions warrant based on our backtested quantitative metrics. Just because equities rallied in the fact of negative internals up until recently does not mean caution was not warranted. On the contrary, we speak from the standpoint of knowing the actual market's history, and a repeated bet on stocks when led by defensive sectors, bond strength, and commodity weakness would not result in optimal results. One should judge results by the process and reasons for the conclusion, in addition to the conclusion itself and how that conclusion would fare over multiple iterations of the same scenario. If normalization is about to occur, then the cyclical trade provides ample opportunity for the rest of the year.
One final note - I am proud to announce that the 2nd edition of Intermarket Analysis and Investing, written by my father in 1990, is now available. If you happen to write Amazon reviews, please feel free to provide an honest commentary on the book at any time. Finally, to learn more about our inflation rotation strategies and how they might fit into your portfolio, feel free to reply to this email. I also recommend checking out Ed Dempsey's latest market video on our Youtube channel.
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.