"Hindsight is wonderful. It's always very easy to second guess after the fact." - Helen Reddy
The S&P 500 (SPY) fell as the Dow Jones Industrial Average (DIA) had its worst week of 2013, while emerging markets continued to show solid outperformance. Regular readers and followers know I have been pounding the table on the emerging market trade as of late, calling it "the next fat pitch." The spread of most emerging markets (EEM) relative to the S&P 500 is the widest its been since 1998 when an actual event occurred to justify such a spread. Valuations are both historically cheap, and considerably better than the U.S. stock market now. Signs of a pickup in economic activity in China (FXI) have boosted overall sentiment on commodity exporting countries. And while the US Russell 2000 over the past two weeks has fallen 3.3%, most broad emerging market ETFs are down around 1%. Alpha has overwhelmed beta, and leadership looks extremely early and very much confirmed.
Why then did we rotate out of our emerging market exposure at the end of last week in our mutual fund and separate accounts? Due to the weekly nature of our buy and rotate alternative strategies, enough deterioration had occurred to cause us to move out of stocks, even though emerging market strength seems to very much be in place. Last week a significant jump in bond yields occurred, as panic appears to be setting in on long duration fixed income. On MarketWatch, I countered an article arguing not to worry about a 1987 repeat by specifically stating that there are parallels to the environment pre-1987 Crash here in 2013. The overwhelming distortion that occurred then was massive stock market outperformance relative to bonds (TLT) which broke down as yields spiked. The same type of behavior is occurring now as stocks and bonds very quickly get out of sync.
Does that mean a Crash is guaranteed, or that we are "calling" for a collapse? No - unlike in 1987, central bank paranoia over an end to the wealth effect is a key difference. However, markets can move faster than the Fed, and very near-term the yield spike of last week can be problematic. A spike in interest rates is not like a spike in a stock like Apple (AAPL). Interest rates drive everything. My contention is not level, but speed and relative behavior against stocks which looks eerily like the pre-1987 Crash. This is not hysteria, and those who have followed our intermarket analysis over the past three years know we approach things logically. We would not be bringing up our concerns in the very near-term if this were not something we believed was important to bring up analytically. I addressed this and much more in a lengthy interview which I highly recommend viewing.
None of this changes the emerging market fat pitch idea. On the contrary, they likely continue to be the leader following any kind of a correction we may now be in. Next week will be important given the possibility that the Fed comes out and tries to calm the bond market. However, I do think the Fed is in a nasty spot here. The simple use of the word "taper" has caused rates to spike ahead of the Fed actually announcing and enacting a change in policy. With hindsight, this may be the moment the market realizes just how difficult it will be for the Fed to manage price movement and step away from bond buying. The implications for financial markets going forward could be meaningful.
For now then, we wait. Rising yields are bullish, but not if done in a panic way. Homebuilders (XHB) have been badly underperforming all year. Financials (XLF) relative to the S&P 500 appear to have peaked in July. Discretionary stocks (XLY) and big retailers look like they are all rolling over, with big companies such as Wal-Mart (WMT) getting slammed. Inflation expectations may be about to turn aggressively given some recent weakness in what appears to be a break in trend. Enough is happening now, with the most recent catalyst of yields jumping at the end of last week, to warrant very near-term caution on all stocks, domestic or overseas.
Sure - its entirely possible that we "V" right out of this just like every other juncture where we rotated out of stocks, the VIX spiked, and in the blink of an eye markets recovered (a pattern we have been faced with all year). However, much like the boy who cried wolf, there will come a time when a doozy of a correction takes place despite failed attempts in the past. We will only know with hindsight if this is the start of it, but by then it would be too late to do anything about it. We must manage risk and address probabilities as an alternative manager. Our disciplined process manages risk and addresses probabilities. For now, our models prefer to wait to see how things play out.
Batter up? Looks like we are facing a rain delay…
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.