- Defensive sectors remain well bid despite new all-time highs.
- Risk-on potentially switching to risk-off in weeks ahead.
- Oil, combined with consumer weakness, is the elephant in the room.
"If every day is an awakening, you will never grow old. You will just keep growing." -Gail Sheehy
The S&P 500 (NYSEARCA:SPY) hit new highs last week as Yellen maintained tapering and disregarded a pickup in inflation as "noisy." The Russell 2000 appears poised to break its prior highs in a clear end to the "cap correction" that occurred over the prior few months. High beta momentum names came back with a vengeance, undoing declines in seemingly the blink of an eye. Stocks continue to cheer yet another day that ends in Y, despite continued resilience in defensive sectors which tend to lead prior to difficult market junctures. Utilities (NYSEARCA:XLU) and Consumer Staples (NYSEARCA:XLP) remain strong, alongside Treasuries (NYSEARCA:TLT) which, despite tapering, continues to hold.
Intermarket disconnects remain. Our ATAC models used for managing our absolute return and equity sector rotation mutual funds and separate accounts have done a nice job so far navigating the environment, and continues to be in "risk-on" mode. However, there does appear to be a high probability that a defensive rotation may take place next week depending upon relative market action. Oil may soon tip the scale in terms of forcing a period of volatility on equity investors on the crude awakening that risks remain on the geopolitical front.
There is a meaningful break out taking place in the energy sector relative to the market after a long basing period. From a sector standpoint, this sets up Oil services stocks to likely be a source of momentum focus in the third quarter. What this means for Oil itself will only be known with hindsight, but crude prices seem likely to continue to push higher. This alone could force inflation expectations to increase and in turn may result in the Fed having to walk back on its "extended period of time" pledge on low rates. Recall that Ben Bernanke in 2005-2006 would reference Oil as a reason to raise rates if it forced higher inflation. While higher inflation is what the Fed wants, the issue with this may end up being a repositioning by market participants on the Fed's assessment for how long easy monetary policy will remain in place.
With the VIX (NYSEARCA:VXX) index cratering, and complacency high, we must remain alert to a sudden and sharp reversal in conditions that favor volatility and corrective environments. The time to be fearful is when everyone else is not only greedy, but expressing hubris. The Fed can apparently do no wrong, and the US stock market is incapable of doing harm. The current environment makes the age of moderation look like the age of turbulence. This can unquestionably last longer than most think, but to assume that stocks are the new money market with higher yield ignores the capital structure.
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