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Mutual fund manager, CFA, registered investment advisor, macro
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"Hindsight bias makes surprises vanish." - Daniel Kahneman

Stocks rose to new 52 week highs as money continued to chase upward momentum in developed market equities. Economic data, meanwhile, continues to be considerably less impressive than the stock market thinks. Consumer confidence fell, non farm payrolls missed relatively meaningfully, margin debt set a new record, and bond yields continue to drop. Managers in our industry are getting a feeling of career risk for not being exposed to US stocks, similar to the same sentiment expressed in 1987 and 1999. We have reached a point of extreme optimism that has little to do with reflation reality, and everything to do with mania.

Beneath the surface, deterioration is factually increasing. Long duration bonds relative to the S&P 500 (NYSEARCA:SPY) have performed roughly in line with each other since late July. Inflation expectations continue to fall, and economic data is confirming that in an undeniable way. Financials are not leading the market, small-cap stocks (NYSEARCA:IWM) have not made new ratio highs, and defensive sectors are strengthening. Despite equities on an absolute basis continuing their run, the "risk-off" behavior we brought up a couple of weeks back is under way. While this does not guarantee that a correction or turn in stocks will come, it historically increases the probabilities of it.

It is often said that every correction ultimately needs a catalyst. We believe there is a growing possibility that the Fed may acknowledge speculative risks in financial markets next week. On the one hand, the Fed is afraid to taper because the economy clearly is not accelerating in the way they hoped. On the other hand, SuperBen and the League of Extraordinary Bankers appear to be risking another stock bubble given the pace of stock gains and the divergence of those gains with revenue and reflation. The prudent thing to do would be to warn financial markets to taper enthusiasm and allow Fed stimulus measures to filter through to the economy, rather than into a single asset class.

Our ATAC models used for managing our mutual fund and separate accounts remain positioned in long duration bonds, and the trade is working well thus far. From a diversification and rotation standpoint, we are pleased with how the year has played out given little overall exposure in US averages and the alternative nature of our trading. As to emerging markets (NYSEARCA:EEM), I have in the past on Bloomberg noted that there appears to now be a strong relationship between inflation expectations and relative outperformance in BRICs relative to the U.S. As inflation expectations have fallen, emerging market stock leadership has waned. A trade back will eventually come back for us there, but in the near-term our models simply favor duration over beta.

If the Fed begins to warn of excess risk-taking next week, then the Santa Clause rally may not come. The Fed needs time for its stimulus to reverse falling inflation expectations. The more the stock market rises, the less time they have for those efforts to work before another bust comes.

Source: The Fed's Surprise?

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.