"The key to winning baseball games is pitching, fundamentals, and three run homers." - Earl Weaver
Following the end of a powerful 3rd quarter for the S&P 500 (SPY), investors turned their attention to the government shutdown and debt ceiling fiasco. Last week's writing downplayed Washington given that the market is still likely digesting the Fed's non-taper from the week prior. Analysis of prior shutdowns suggests that market behavior tends to be mixed across asset classes given limited duration, and the belief that the US would never default despite political grandstanding.
The biggest beneficiary of this appears to be emerging markets (GMM), which strongly outperformed US averages by being up more and down less than the S&P 500. Strength is gathering steam in the fat pitch, and behaviorally it does look like institutions are buying. On every single day since October began, the alpha spread of emerging market ETFs has widened into the end of the close, suggesting that "smart-money" is allocating to one of the most hated trades in markets. I can not stress enough how much potential our work suggests emerging market stocks have. Valuations are cheap, economic data is improving, central banks have acted, and negativity is extreme. The Washington drama is providing just the right excuse for investors to rotate out of extended US averages into unloved BRICs.
Many argue that there is no point to investing in emerging markets when US stocks, and most notably US small-caps (IWM), have "all the momentum." Yet, facts are undeniable. Since July, emerging markets have OUTperformed US small-caps, and the ratio chart looks classic and early. Meanwhile, emerging markets are still lagging the S&P 500 by a huge amount for the year, and when they run, they run considerably faster than US markets. This is not about opinion, but rather a rare opportunity where upside relative momentum from a pure quantitative perspective is high.
What about a correction and long bonds? For now, our ATAC models used for managing our mutual fund and separate accounts still favor emerging market equities, but are close to a defensive deflation rotation. To re-emphasize, intermarket analysis suggests that both US bonds and US stocks have priced in reflation that does not exist, while emerging markets have priced in a crisis that was make believe. It is possible that Brazil, Russia. India, and China alpha overwhelms overall negative equity beta in US averages. However, if we get our asset class trigger, we will trade out of equities into bonds regardless of alpha momentum in the price ratio.
Next week will likely be an important one to watch. If indeed a "great rotation" out of developed and into emerging is underway, then positive sentiment on global activity and asset markets could keep beta sentiment alive and keep US markets elevated in the short term as those markets play aggressive catch-up. This in turn might delay a big correction, which we believe would be on a resync of stocks to the reality that deflation pressures are still characteristically building underneath the surface.
Our inflation rotation strategies were never designed to be a buy and hold alternative, but rather a buy and rotate solution. From management of our separate accounts and backtesting, the return pattern tends to be less smooth and more spike-like. Despite the way US markets have behaved this year, most returns are not driven by constantly hitting the ball, but rather by hitting the ball hard when there is a fat pitch.
The illusion of stability has more often than not fooled many investors into extrapolating the past into the future. And while many claim to want to buy low/sell high, few do so in practice. This, over time, tends to be precisely why the market enriches only the few, and tends to frustrate the many.
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.