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"We must all suffer one of two things: the pain of discipline or the pain of regret or disappointment." - Jim Rohn

Oil has been breaking down fairly quickly over the past few weeks, notably diverging from the behavior of stocks despite the two being closely correlated in terms of overall direction for the bulk of 2013. We all know how important Oil is to the economy, but what may be less appreciated is its role on inflation expectations. When Oil prices rise gradually, the move tends to be seen as demand driven and inflationary. The idea here is that as energy costs increase, so too does the likelihood of corporations passing down that higher cost to the end consumer. However, if Oil prices spike, that actually tends to be seen as deflationary since a fast move higher makes it unlikely companies can react fast enough, negatively impacting margins. A spike down in Oil prices could be very good since such a decline likely occurs from a supply increase, benefiting company profits. A gradual decline lower, however, is often considered a sign that demand in the overall economy is waning.

As such, it's worth considering what the recent decline in Oil prices means despite hope for further stimulus from a Yellen-led Fed. Sure, one could argue that falling Oil prices are bullish for equities. However, if the reason for the decline is a drop in growth and inflation expectations, then it is a bearish signal for "risk" assets. Our ATAC models used for managing our mutual fund and separate accounts have positioned our client assets into long duration bonds recently due specifically to another deflation pulse beating beneath the market's surface. Recent jobs data continues to confirm this. The connection here is simple. Falling Oil prices which occur alongside falling yields is a reflection of concern that reflation is not happening, growth is slowing, and deflationary pressures are growing.

What is being missed here is that if this move is early, it could be a significant headwind on stock sentiment. Take a look below at the price ratio of the United States Oil Fund (NYSEARCA:USO) relative to the S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/USO outperforming (up more/down less) the denominator/SPY. Note just how severe underperformance is here, as alpha built up over 3 months positioning in Oil gets taken away in 6 weeks.

(click to enlarge)

What is it that is bothering the market here? Some may argue seasonality, but that seasonality does not explain the consistent message of falling inflation expectations, falling yields, and falling momentum in jobs growth. The stock market continues in the US to ignore these messages. That does not mean you should too. Yes - momentum in US equities continues unabated despite multiple periods of potential corrections. But much like the boy who cried wolf, at some point these disconnects will resolve.

When and when...

Source: Oil Pain = Bond Deflation Gain

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.