"The Promised Land always lies on the other side of a Wilderness." - Havelock Ellis
The S&P 500 (NYSEARCA:SPY) closed down marginally last week as yields rose on a better GDP print and improving jobs data. Much of the week was defined by anticipation of the Friday Non-Farm Payroll report, which appears to have brought the Fed's "taper" back on the table. Interestingly though, bond yields fell Friday, and emerging market stocks soared. At first glance, this may appear counterintuitive since bets on tapering would likely cause yields to rise (NYSEARCA:TLT) and emerging markets (NYSEARCA:GMM) to weaken. Rather, Friday's reaction resulted in quite the opposite, indicating that not only may tapering be priced in and largely discounted, but resilience in overseas markets is increasing.
As noted in several writings, emerging markets since June have performed roughly in line with US stocks, despite continuous hand wringing about how poor they are as investments. The ratio of broader emerging markets to the S&P 500 has held strong support since then, and catalysts are very much in place for a real mean reversion trade to occur into next year. If indeed US stocks are right about the future and inflation expectations rise, it is illogical to assume the suppliers to developed economies do not benefit. With many emerging economies still negative on a year-to-date basis in 2013, buy low, sell high may be too tempting to ignore, especially given the historical speed and aggressiveness with which emerging market stocks tend to move.
Meanwhile, the breakdown in Bitcoin (which the media seems to be in love with lately) is a gentle reminder that gains are only permanent in the moment, and not guaranteed in the future. Those who decide to arbitrarily compare all strategies to a constant beta equity portfolio are simply cherrypicking that which is most visible regardless of risk/return characteristics and stated objectives. For the bulk of last week I wrote specifically about this issue at length. No one ever seems to ask their advisors why their portfolios aren't up as much as Bitcoin this year, but seemingly always compare their portfolios the S&P 500.
Moderate allocation strategies are up around 9% year to date, and hedge funds are up around 6%. Neither can be compared to the S&P 500 alone because those portfolios are purposely not constant 100% beta strategies. Furthermore, given just how severely developed equities diverged from nearly all other asset classes this year, one should consider positioning into laggards turning into leaders, not extended performers. In other words, the time may be ripe for a contrarian trade on the unthinkable idea that non-US stock investments can rise in price. Its also worth considering the idea that risk management still matters, and sometimes the best risk management comes from investing in areas which have discounted "bad news" considerably. Friday's price action in bonds and emerging market stocks may be indicative of that.
Will the Fed taper or not no longer matters. The bubble of divergence between US stocks and inflation expectations will pop with either US stocks breaking down meaningfully, or inflation expectations rising. If the former, investors will be reminded that there are no free lunches, and that trends reverse. If the latter, emerging markets could pull a surprise and significant move to close their spread relative to the S&P 500. From an intermarket standpoint, this appears to be the more likely scenario in the very near-term.
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.