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Mutual fund manager, CFA, registered investment advisor, macro
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"There was a lot of stress and assumptions made without me even saying anything, which was very upsetting." - Craig Stevens

Stocks fell last week as financial media outlets focus on the "crisis" in Washington as the next iteration of the debt ceiling plays out. This does not actually seem to be what is causing some nervousness among equity investors however. Rather, what may be happening now is an epiphany by traders and investors who are starting to realize that the Fed's non-taper the week prior, alongside lowered growth forecasts for 2014, actually suggest things are not as rosy as the S&P 500 (SPY) would have one believe. Yields continued to fall, countering the entire "rising rate environment/normalizing yields" meme that many have been arguing for since the May taper talk began. I have said this before and it bears repeating: you can not normalize yields unless you also normalize growth and inflation.

Ironically, stocks fell when taper talk took hold from mid-May to June, and are now dropping after the Fed said no taper at all. The economic data simply does not support an easing of stimulus. Ed Dempsey and I have been arguing aggressively all year that inflation expectations have been falling in a way that is highly unusual. I have on numerous occasions argued that Fed tapering is nonsense in light of this as strong deflationary pressures continue to persist. The Fed's favorite measure of inflation, core PCE, continues to trend much lower. The epiphany that may be underway is the realization that both US stocks AND US bonds have priced in reflation which never took place. On Bloomberg I made it a point to specifically address how abnormal 2013 is in light of the on-going deflation pulse.

On that note, I want to address something outright which needs to be said for regular readers and followers of our analysis and our inflation rotation strategies. I have received unsolicited, random emails from people who have completely mistaken impressions of what we do. Our entire approach is based on an observed correlation and causation between market behavior and investing conditions. We have gone so far as to trademark "the inflation rotation manager" because in our work, there is a very strong historical relationship between the direction of inflation expectations and the conditions which cause stocks and bonds to move. Those who recall our very strong performance in 2012 for our separate accounts can attest to this.

Some have yelled from the stands saying "you are underperforming the S&P 500." This assumes very incorrectly that equities are our benchmark. Deflation has undeniably characterized 2013. As the inflation rotation manager, we have done precisely what we are supposed to do by being more in bonds than stocks all year because of this, managing duration along the way. Why the comparison to buy and hold stock trades in the US is done is beyond me, when a more appropriate comparison might be against long duration bond ETFs (TLT), which are down heavily for the year and are traditional ways of expressing a trade on deflation. We are not an equity manager. We manage a liquid, alternative, absolute return strategy that may or may not outperform any single asset class. If in a recession and stocks crater because recessions are defined by deflation expectations, it would be completely inappropriate to compare us against stocks since we would likely be in bonds during such junctures.

We are an alternative manager that offers a very different type of strategy, and make no apologies for sticking to a backtested, disciplined process. Since taper talk began, many market relationships became unhinged from reality and disconnected from the past. To assume that disconnects do not get resolved ignores market history. Stocks are NOT supposed to be a deflation hedge. If you believe they are, I recommend moving to Japan (DXJ) and reviewing the history of the Nikkei (NKY) since 1989. Markets have completely divorced themselves in 2013 from causation and correlation. This is the first time in history QE has not caused an increase in inflation expectations, and this is wildly dangerous if this persists as it suggests the Fed now truly is risking not its inflation fighting credibility, but its deflation fighting one.

So what happens next? Our ATAC models used for managing our mutual fund and separate accounts remain in emerging market equities (GMM) into next week, with the potential for a full aggressive rotation into long duration Treasuries. I have continuously called emerging markets the "next fat pitch" and IF inflation expectations begin to turn around sharply in a positive way, it would appear they are the way to trade it as I showed in the Bloomberg segment earlier referenced. If, however, this is the start of a correction in beta as investors in both bonds and stocks realize there is no reflation, then the fat pitch is wrong. Why? Because it would imply that emerging market investors were right to be bearish on global growth all year through their failure to participate in the developed market rally. The fat pitch then may be something which no one thinks is possible - a downward re-sync of US markets to the reality of deflationary pressures which $85 billion a month has failed to eliminate.

Context matters, stocks can overreact and buying the past tends to be a surefire way of being disappointed with the future.

Source: The Deflation Epiphany?

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.