"Ability will never catch up with the demand for it." - Confucius
The S&P 500 (SPY) closed lower on the week as intermarket behavior continues to look increasingly different from last year's outlier environment. Up days showed consistent risk-on behavior, while down days resulted in defined risk-off leadership. Markets are behaving more normal than in 2014 as daily swings increase, and investors begin questioning PE expansion last year. We are encouraged to see risk-on/off dynamics return to markets regardless of whether the near-term results in an advance or decline. To see correlations trend back to historical levels is precisely the right kind of environment for alternative, tactical, buy and rotate strategies.
On balance, it appears bonds (TENZ) may be due for a period of outperformance relative to stocks overall. The two most bombed out trades are fixed income and emerging market (EEM) stocks. Despite absolutely no confirmation of a crisis in emerging market debt, emerging market stocks are clearly exhibiting negative momentum, primarily due to China (FXI). This momentum is illogical as crisis pricing continues, even though the debt side clearly says equities are wrong. However, until relative movement improves, it is a difficult trade to make as opposed to investment.
Bonds, meanwhile, especially long duration Treasuries, continue to firm. On December 23rd, I argued live on Bloomberg that Retailers (XRT) may be on the verge of a reversal. I noted that with the yield curve potentially looking to compress, the market may be starting to question demand pull inflation. A severe relative breakdown in Retailer stocks has taken place since, and bonds are rallying in price despite the "rising rate environment" meme. Nearly every single day last week, inflation expectations ticked lower. Between the behavior of consumer sensitive stocks, massive bearish sentiment on Treasuries, and still no real signs of pickup in inflation expectations, perhaps the real surprise is a great rotation back to bonds from stocks.
That does not mean stocks have to falter, but if economic data does soften and earnings on balance disappoint, it will be hard for equities to hold on to the PE expansion exuberance of last year. Furthermore, with the Fed on its path to tapering and growing doubts over QE's efficacy, we continue to see signs of more normal behavior which our models are picking up on. The real bear case here is that if reflation expectations do not soon reverse, it will be hard for equities to justify their valuations. This is not our base case, but it is worth considering that a trade in bonds can be made should last week's intermarket behavior continue.
I have decided to hold off on the final part of the "Revealing ATAC" series for now, primarily because I prefer to fully explain how to rotate across asset classes for a coming white paper my Director of Research, Charlie Bilello, and I will be working on. We are in the midst of finishing up an important writing which will be submitted to a competition, and touches on some of the ideas referenced in prior writings. Unlike other shorter articles though, the white paper will take on a far more detailed and academic tone. We are excited to put these papers together as it will for the first time provide a comprehensive overview of prior academic research which validates intermarket analysis, and in turn should prove that it is absolutely possible to outperform broad markets through dynamic rotation over multiple cycles. For financial advisors interested in getting a sneak peak of the writing, please feel free to reach out to us at any time.
Finally, it is worth considering that market gains are not a right, and that the past is not necessarily representative of the future. If a sobering up moment is to come for US stocks, then disconnects can get resolved, and opportunities to profit can be made by not following the crowd, and instead adhering to time-tested cause and effect.
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.