When Butterflies Attack

Jun. 8.14 | About: SPDR S&P (SPY)

Summary

Stocks cheer yet another week with days that end in Y.

But the why is questionable as negative ECB rates may be deflationary.

Complacency at historic levels, and may result in severe breakdown later in year.

"What's a butterfly garden without butterflies?" - Roy Rogers

The S&P 500 (NYSEARCA:SPY) rose to a record high as investors cheered the European Central Bank's latest round of stimulus and US payroll data which was in line with expectations. US small-caps (NYSEARCA:IWO), which suffered the brunt of selling over the past several months, appear to want to take a run at new highs and play short-term catch up to large-caps following their alpha crash. Emerging markets (NYSEARCA:EEM) look to be improving once again, with Brazil (EWan area of focus. The VIX index has been utterly destroyed, as volatility in equities is nowhere to be found.

Risk apparently does not exist. I've seen many argue that stocks love a low VIX. This is incorrect. A low VIX loves stocks because the VIX index is reactive and NOT predictive. The areas of the market which tend to be predictive and react off of inflation expectations have indeed been sensing improving sentiment. Utilities and Treasuries (both inputs in our ATAC models used for managing our mutual funds and separate accounts) are on a rolling basis lagging. How long this lasts is unclear, however. Investor sentiment surveys show bullish levels last seen in 1987 and 2007. It appears absolutely no one believe stocks can ever fall again, and the "staircase up/elevator down" analogy appears to long be forgotten.

I titled this week's writing "When Butterflies Attack" for a very simple reason. I've always found chaos theory interesting. The idea that in a non-linear system a minor change can dramatically alter final outcomes is highly relevant in the world of the stock market. Most refer to this concept as the butterfly effect, whereby a butterfly flapping its wings in India, for example, could in turn cause a hurricane in New York.

On CNBC (click here), I argued that Draghi's decision to create negative rates in Europe was the equivalent of bringing a butter knife to a machine gun fight. Why? Because first of all, -0.1% interest on excess reserves is likely too small a tax to alter bank lending in a region where demand for credit simply isn't there. Second of all, there might be unintended consequences with such a move. Rather than having an inflationary effect, negative rates may simply result in European banks passing down that cost to their own depositors in the form of higher bank fees. This in turn would be deflationary, as it would take savings out of the system without any real desire or need to spend now. If the goal of negative rates is to force lending, the effort may end up backfiring, yielding a very different result than what was originally intended.

No one wants to make the bearish case, and investors appear to be more and more all-in. For now, intermarket trends remain positive, but with the trade as crowded as it is, I suspect a strong about-face move is coming which could leave many surprised. All this means in practice is that it's important to stay vigilant with asset allocation positioning here, which is yet another argument in favor of using a weekly buy and rotate approach which manages risk dynamically. From an equity standpoint, it does seem plausible that small-caps make another near-term run followed by emerging markets for leadership position. In our long-only equity sector rotation strategy, our models most favor the Materials sector which is where we have a significant overweight. That sector, along with emerging markets more generally, appears poised for more continuous outperformance potential than other areas of the equity landscape.

One final note. This Wednesday, Charlie Bilello and I will be presenting a webinar hosted by the CFA Institute titled "Generating Alpha: Predicting Volatility and Corrections." The webinar is free and can be accessed by clicking here. The event is eligible for 1 CE credit hour. I highly recommend followers of our work register through that site and attend. We will be discussing our award winning papers, and how you can implement some of our research in your own portfolio management.

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.