"Risk comes from not knowing what you're doing." - Warren Buffett
Following a strong Thursday and Friday for the S&P 500 (SPY), markets rose on hopes for a coming deal out of Washington, alongside some delayed bullish excitement over the Janet Yellen Fed nomination. Emerging market strength (EEM) continued to support overall beta sentiment, and negative news for the most part seems to be largely ignored by investors. Several large institutions decided to front-run risks by selling 1 month T-bills in the event the debt ceiling is not increased, causing yields to spike. After the close Friday, the CME hiked margin requirements for several large-cap futures indices on leverage concerns.
While likely a deal will be reached to avoid default, what is less certain is what it takes to get us there, and if spending cuts/deleveraging ends up being the ultimate direction policymakers go. Spending cuts would serve as a drag on growth and reflation, both of which are questionable at best given intermarket behavior and recently lowered forecasts for both by the IMF and the Fed. Earnings could certainly also disappoint and remind investors that the economy is not accelerating in the way some may hope. Global growth concerns may also flare up on recent economic data coming out of China showing disappointing export activity. There are more than enough reasons for US stocks to be vulnerable here.
Our ATAC models got our primary asset class rotation signal, causing us to position out of emerging market stocks (which had been a very strong trade the last several weeks) into longer-duration Treasuries. Bonds never sold off aggressively following Thursday and Friday's big moves higher for US averages, and defensive sectors are gaining relative momentum versus big cap indices. The deflation trade was not convinced of last week's optimism surge. This does not take anything away from the emerging market trade given continued strength there, but at least for the very near term bonds may be a better trade than stocks overall. Should a traditional risk-off period occur, the alpha momentum in the BRICs would matter less than overall downside beta pressure.
Finally, I do think it is important to consider some facts as it relates to the way US markets have acted in 2013. Over 80% of year-to-date gains are attributable to the January-mid-May period. While everyone seems to be talking about how strong stocks have been, the reality is that not much extra has been gained since that period despite the Federal Reserve pumping in more than $400 billion/month into the financial system. There seems to be a lack of appreciation for risks building beneath the surface and justification for "PE expansion" when there has been no expansion of inflation expectations. Perhaps Washington is the catalyst for that realization, perhaps earnings are.
You don't need to be all in on stocks and expose yourself to constant beta risk in order to have strong returns over time. Rather, mathematically it is important to minimize downside risks and potential losses. Such periods tend to occur when bonds look set to outperform stocks on deflation expectations rising. While it may feel impossible for equities to fall ("buy the dip"), I assure you that it is often at the most extreme of convictions that turn out to be wrong. More people have suddenly turned bullish on emerging markets than bonds, and yet just like before the Summer Crash of 2011, bonds are not believing the same thing stocks are.
Should be an interesting week…
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.