"A good many dramatic situations begin with screaming." - Jane Fonda
The S&P 500 (NYSEARCA:SPY) and bonds rose last week as the debt ceiling drama was resolved (for now). Aggressive hedging by traders on the possibility of a US default reversed as money rushed back into markets. The " buy the dip" mentality continues to push intermarket disconnects to ever wider extremes. Headline after headline stated that stocks rallied on the debt ceiling can kick, as if there was a repricing upward to adjust for default probabilities. However, equities never really fell hard into the deadline. We are getting to the point where money powerfully reprices upward stocks which never priced in downward a negative outcome to begin with.
On Twitter, in the media, and in writings, no one is willing to stick their neck out to argue US stocks can fall. However, we maintain consistency in what our analysis shows to be true. US stocks and bonds have priced in reflation which does NOT exist. While stock bulls are screaming about another surge higher, the "rising rate" conviction is being countered. Bonds continue to show strength as the yield curve looks to compress, indicating that the "deflation epiphany" I referenced a few weeks back may be underway. Put simply, the bond market is now starting to realize it should never have aggressively sold off to begin with.
There is no taper. Revenue growth is not there. Economic growth continues to be tepid. US stocks have rallied on "PE expansion" and are now considerably more expensive than they should be in the face of future growth and inflation expectations. Money that is in the market is not only all-in, but all-in with leverage given the explosion higher in margin debt. Sentiment has gone to nosebleed bullish levels, and long positions in index futures have surged. People are fitting a narrative to the advance in equities, ignoring the reality that this is the first time ever we have had an aggressive round of stimulus/QE without reflation repricing.
Many want to be contrarian in thinking, but few do so in practice. Strength in long duration bonds, which our ATAC models used for managing our mutual fund and separate accounts are currently positioned in, seems to be building very quietly. Fragility and one-sided conviction remains something to be concerned about. Excitement by those "investing" this year is likely similar to the exact same emotions felt in 1987 and 1999. That does not mean we have to collapse from here, but factually into this advance risk-off behavior internally seems to be building. Defensive sectors of the market appear to be firming on a relative basis, and bonds are improving. From a risk/reward standpoint, and from the simple logic of "buy low, sell high," US stocks look to be considerably more vulnerable to a decline than bonds (and emerging markets) in the near-term.
Next week may provide clearer signals on what happens next. Yes - the rally in US stocks can continue, just as it did throughout 1987 and 1999. However, we are at the point where the reflation disconnect is at very extreme levels. Major cracks happen in stock markets when they are preceded by complacency, a sense of entitlement, the illusion of stability, and leverage. While many tell stories to explain why stocks are doing what they are doing (a/k/a the narrative fallacy), our process and approach has been consistent and disciplined. Stocks can fall, and do so aggressively when disconnected from reality and on realization of failed expectations.
A blow-off move higher is only labeled a blow-off way after the fact. We would not be so stubborn, standing alone making a negative case for US markets, if inflation expectations agreed with stock euphoria. For now we maintain that we could very easily be at the very start of a risk-off period despite the recent surge higher following the government debt deal. What stocks seem to be ignoring is that any ultimate deal will likely result in some form of tax increases (deflationary) and cutback in government spending (deflationary), against the backdrop of a private sector that is not accelerating.
Bonds are beginning to realize they made a mistake, apologizing to bulls. Stocks may be next to say "I'm sorry" to the bears.
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.