"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury
The S&P 500 (NYSEARCA:SPY) broke down across the globe last week as Treasury yields (NYSEARCA:TENZ) tumbled, the Yen (NYSEARCA:FXY) strengthened, credit spreads widened, and the VIX (NYSEARCA:VXX) surged. I have been noting for the past few weeks that intermarket trends appear to be normalizing as we move further away from 2013's outlier environment. The media is heavily focused on the emerging market (NYSEARCA:EEM) crisis, but as I show in my coming Marc Faber piece, weakness is a symptom. The cause remains the deflation pulse which began expressing itself a year ago, and which everything but developed equities priced in since.
Our ATAC models used for managing our mutual fund and separate accounts picked up on meaningful internal fragility following the payroll report which sent Retailers on a relative basis down heavily. This resulted in us getting fully out of our equity exposure to be in deflation mode. Unlike 2013 however, this time the deflation momentum is in long duration Treasuries which we are currently positioned in, and which had a strong move higher as equities fell. The Yen, Gold (NYSEARCA:GLD), and volatility are all sending the same consistent message that is reminiscent of risk-off periods in 2011 and 2012 - two years where our models performed well by getting defensively positioned prior to corrective periods. We are happy to see the market refresh the idea that risk exists, as this juncture should serve as a reminder that our main strategies are absolute return and NOT constant stock exposure.
Neither China (NYSEARCA:FXI), Turkey (NYSEARCA:TUR), Argentina, or any other country has anything to do with consumer stocks badly underperforming following a stellar year for US stocks which in turn was supposed to help consumers through the wealth effect. The complacency is most acute in developed economies. Indeed emerging market momentum remains weak, though time horizon is important. GMO's forecasts indicate emerging market equities as an investment are a great place to be, and we agree over a longer horizon. However, they simply can not sustainably outperform in the near-term unless inflation expectations in the US definitively turn. In the event that the February payroll report disappoints, panic will turn inward. The question will no longer be about how the Fed tapers, but if QE is actually working to begin with.
Has the correction begun? We will only know with hindsight, but the odds do favor a period of falling stock prices in the near term given strong negative movement confirmed in multiple asset classes. People became conditioned to think stocks could not erase months worth of gains in a single week, but we may be in the early stages of an end to that amnesia. More wealth is created through the management of risk than through the mismanagement of return. It is the management of risk that separates the men from the boys in the business of investing. To that end, defensiveness may be what characterizes the months ahead. For us, that's a great thing, as it only increases the probability of a washout in emerging market stocks, and rip higher when momentum kicks in which we hope to take advantage of. Likely very few will participate in that move or think it will happen, just like very few thought Treasuries would be as strong as they have been so far in 2014.
Risk management is back.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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.