"The excessive increase of anything causes a reaction in the opposite direction." - Plato
I think with hindsight, last week will be known as the week of global overreactions. Prior to the FOMC decision Wednesday, stocks rallied very strongly, only to have gains reversed as Bernanke suggested that Quantitative Easing could end by the middle of next year if the economy picks up. The Fed, which consistently is more optimistic about the economy in their forecasts, believes deflationary pressures are "transitory," while the market's internal pricing mechanism and economic data is suggesting quite the opposite. The Dow (DIA) fell 560 points in two days, interest rates shot up, and quite literally everything declined in coordinated fashion.
However, the entire sentiment in the bond market is not supported by inflation and growth expectations the market itself is acting on. The Fed made it clear that if the economy falters and their growth estimates are too high, they will react accordingly. That means that the Fed could ultimately do more stimulus, and the fact of the matter is that every time the Fed has tried to pull away, they've had to only come back in months later. I find it hard to believe the Fed wanted to engineer a meaningful spike higher in rates given that history shows a sharp rise in the cost of money can serve as a deflationary shock to the economy.
I suspect bonds (TLT) will likely begin to rally rather strongly in the coming weeks, given that real yields have risen and inflationary pressures are largely non-existent. Global growth estimates continue to be cut, and overseas markets have been far from robust. US equity averages have no where near priced in as much negativity as emerging markets, which in turn leaves the Dow and S&P 500 (SPY) more vulnerable.
I maintain that a significant move in emerging markets (EEM) can occur given valuations and the fact that every single article I see out there is making the case that emerging markets are in severe distress and an awful investment. I will remind readers that March 8, 2009 the world was coming to an end and no one was bullish on U.S. averages in what seemed like an "obvious" collapse to come. Nothing in markets is ever obvious, and nothing that is in the news is not already known. If it's reported, it's by definition old and already discounted in price. Too many overestimate their own knowledge, ignoring the fact that history is full of examples where the majority simply get it wrong.
The entire market was clearly shocked by the reinforcement of the idea by the Fed that tapering of stimulus could begin soon. The very fact that everything sold off in unison globally tells you the market was not priced for that. Don't fall prey to hindsight - it was never obvious last week would play out the way it did. Our ATAC models used for managing our mutual fund and separate accounts continue to favor bonds, which despite their breakdown are likely much more attractive that stocks given the very real possibility that the Fed might begin to try to undo some of the damage that occurred last week. We use a backtested, quantitative model which can not be rationalized by "why this, why that" subjectively, but rather by historical intermarket behavior, cause and effect, and relative momentum.
Finally, as I have said continuously in my writings and on-air, rising interest rates are good IF they are gradual and reflective of demand for money. The Fed continues to buy $85 billion/month, deflationary forces are undeniable, and growth is far from exciting. If you liked bonds before at historically low interest rates, you should love them now given that the outlook for inflation simply hasn't changed yet.
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.