Underappreciated Risks

Jul. 1.13 | About: SPDR S&P (SPY)

"If you are not willing to risk the unusual, you will have to settle for the ordinary." - Jim Rohn

Both the S&P 500 (NYSEARCA:SPY) and bonds (NYSEARCA:TLT) rallied from oversold levels last week as numerous Fed officials came out "clarifying" monetary policy and the timing of QE tapering, helping to calm concerns of a near-term shift in bond buying. The Fed's confuse and conquer strategy sent money fleeing from fixed income, which as an asset class saw historic weekly outflows from investors. The yield spike came out of nowhere, and is largely driven by irrational reasons. Inflation expectations (NYSEARCA:IPE) continue to be poor, economic growth remains depressed, global markets are weak, and deflation remains the biggest risk. Simply put, if you step back and look at the weight of the evidence, any spike higher in yields is likely a very good buying opportunity in the absence of any real change to growth and inflation.

And yet, all I hear is this mantra and overconfident assumption that "we are in a world of rising rates...the bond bull market is over." For the bond bull market to be over, a bull market in growth and inflation needs to be underway. It simply is not. You can not look at yields and say we are in a process of "normalizing rates" if inflation and growth are themselves not normalizing. Cost-push inflation is falling by the day as Gold's collapse seems to indicate. Demand-pull inflation is muted given mediocre job growth, aging demographics, and household debt relative to personal income. Rising rate environment? What has happened here is not a fundamental re-adjustment, but a liquidation driven by irrational market players. Nothing has changed. If you liked bonds before, you should love them now.

Our ATAC models used for managing our mutual fund and separate accounts on a short-term basis continue to favor bonds over stocks, which have been the last thing to break on the global stage. Commodities (NYSEARCA:DBC), emerging markets (NYSEARCA:EEM), bonds, Japan (NYSEARCA:DXJ), and nearly everything but the U.S. Stock market has fallen aggressively in compressed time periods thus far in 2013. Investors looking only at the Dow and S&P 500 are suffering from severe home bias if they think year-to-date gains there are reflective of better times ahead. Everything else around the globe is sending a clear signal that the environment is not as bullish as some thing.

Furthermore, there is tremendous underappreciation of how high the risks are now in terms of strategy execution. Between the U.S. Fed potentially paving the way for tightening, and China (NYSEARCA:FXI) itself allowing higher funding stress to clamp down on shadow banking, the odds of a miscalculation by policy makers from the 2 largest economies in the world is quite high. Ignoring this as a risk in favor of a buy and hold allocation in the Dow (NYSEARCA:DIA) can likely lead to some significant disappointment later on. In addition, if you think stocks historically perform well during deflationary periods, I encourage you to look at Japan over the past two plus decades. There is a reason why we focus on inflation expectations as the driver of asset class returns, and it relates to cause and effect throughout time.

We maintain the idea that tapering is unlikely. The Fed is in a nasty position here. QE forever was only met with downtrending inflation expectations, and the threat of the removal QE seems to be accentuating this even more in the near-term. Every single time the Fed has tried to end bond buying, it has ultimately only needed to do more. Should this turn out to happen again, then the rush out of bonds with hindsight may ultimately end up being not something to be afraid of, but rather something to welcome.

After all, the best trades occur when no one else sees them coming.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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.