[Originally published on 7/2/2014]
Headed into this year, we had looked for the one way street in equities that had led the 2013 Meridian charge to consolidate in traffic - as those markets more impressionable to inflation expectations - or lack thereof - would emerge with the performance baton. Our general thinking at the time was if you were going to be in equities longer-term, look to emerging markets and China - as we read the tea leaves of the US dollar to indicate the backside of strength and working towards a path of least resistance that eventually would lead to the bottom of its long-term range. Accompanying the downside move in the dollar, we expected long-term yields to reverse lower from the relative extreme they notched at the close of last year. We estimated that this shift would be broadly bullish towards commodities and those currencies closely associated - and bearish on a relative performance basis towards the developed markets that have led and enjoyed the disinflationary - but rising yield environment over the past few years.
Overall, our broader macro reads have been borne out with respect to inflation, yields and the dollar. Where we have been off the mark is anticipating where the SPX could stall and the topside range we expected at the start of the year that was closer to 1900 than 2000. That being said, while emerging markets and China still lag the relative performance trend of the SPX this year, we do maintain conviction that a cyclical low was reached for both (relative to the SPX) at the end of Q1 - and the balance of 2014 should provide a continuation of trend higher. Moreover, as resilient as the SPX has been this year, the upside pivots in commodities and long-term Treasuries have still outperformed equities - which from our perspective foreshadows the broader sea change at hand. Despite what the pundits might package for sale in the headlines and sound bites, major shifts in the macro climate do not unfurl overnight.
Rarely a simple read, our opinion on the developed equity market environment has recently bifurcated, as we see Japan finally looking to break free of the deflationary market conditions it has been trapped in over the past 25 years - while Spain gets caught up in similar tentacles. Although a material correction has yet to gather downside momentum, we still expect the tide to go out in the SPX as well - as it did in QE I (-16%) and QE II (-17%), as the Fed steps further away from extraordinary support. With this week's recent strength, the SPX has built a ~ 16% cushion above the monthly Meridian - which comes in ~ 1653 for July. Our best case scenario for the SPX is that the inevitable correction is confined by long-term support, as market expectations normalize in the wake of QE3.
Taking a quick look at where the market stands in relation to the previous Meridian breakthrough in 1995, a wide divergence has recently appeared in the cycle as volatility has been squeezed out of the markets. What's interesting to note is the VIX pivoted lower almost directly where the 1990's irrational cycle took another stair higher in the range. Hindsight 20/20 - the rising VIX was actually a healthy expression of the wall-of-worry that the equity markets strongly climbed with during 1996 and for another three years. From our perspective - and considering the market is fully cognizant of the nearing time horizon the Fed is working towards ending QE - this does present a real irrational complacency in the markets.
Last December, we had worked up a very long-term performance study that was defined by the major momentum RSI lows over the past 80 years. The study primarily encompassed two long-term cycles (as defined by the RSI lows) and the recovery rally that extended from the momentum extreme. With the recent run-up in the SPX, the current recovery rally has now marginally exceeded the proportion that marked the cyclical peak in 1980.