Something fairly significant happened last week which could have meaningful implications on market movement into the end of Quantitative Easing.
Inflation expectations largely have not mattered with the benefit of hindsight since QE3 began.
We are re-entering a period where risk management is going to matter, and the post QE3 era where only buy and hold worked will change.
"I don't want to be interesting. I want to be good." - Ludwig Mies van der Rohe
I've finally gotten a chance to get back from weeks of traveling presenting our award winning papers on predicting corrections and stock market volatility for the CFA Institute, Market Technicians Association, and financial advisors nationwide. I rarely travel and found the experience really quite fascinating. One thing is to write articles and be in the financial media, communicating in (hopefully) an interesting way various intermarket trends and giving voice to our models. Another thing is talking and debating with others in the business to get a sense of on the ground sentiment for stocks, bonds, and the general state of asset allocation.
Something fairly significant happened last week which could have meaningful implications on market movement into the end of Quantitative Easing. While the buy the dip crowd pushed stocks up for another run at new all time highs following the break down two weeks ago, something interesting and negative began happening, and no, it wasn't the complete collapse in Treasury 10 year yields. Rather, it was the collapse in Treasury Inflation Protected Securities(NYSEARCA:TIP) relative to nominal bonds (NYSEARCA:TENZ).
Inflation expectations largely have not mattered with the benefit of hindsight since QE3 began. I have noted in many writings that there are several ways of tracking inflation expectations. One is TIPS relative to nominal. Another is Utilities (NYSEARCA:IDU) relative to the market (NYSEARCA:SPY), since when Utilities outperform, that tends to happen during deflation pulses, and of course so too is a flattening yield curve (the latter two of which are what the Dow Award and 3rd Place Wagner papers cover respectively). One of the main arguments for why Treasury yields have been falling is due to US sovereign debt being relatively cheaper than European bonds. This has always been a dubious explanation, given that small-caps domestic stocks have been having a hard time getting anywhere in 2014.
However, living in the outlier and small sample does not negate the role of inflation expectations. Last week, TIPS relative to nominal Treasuries very meaningfully underperformed. This is a major change that, should it stick, suggests that what is happening now is NOT about Europe, but domestic concerns as forward looking investments worry about a potential credit spread blowout. This does look like 2011, where bonds are screaming and stocks are ignoring their message. One could easily argue the disconnect between what stocks think and what bonds think does not matter given how long the disconnect has been on-going. Being numb to a problem does not mean the problem has gone away.
We are re-entering a period where risk management is going to matter, and the post QE3 era where only buy and hold worked will change. Yield movement is signaling an event is coming. This does not mean one will, but bonds tend to be more right than stocks. If risk is going to matter and bonds are right, then every single trader, investor, retail client, and institutional investor will be reminded that the key to wealth accumulation is NOT small samples of time where stocks move up in a major way, but rather the avoidance of big losses. This is a factual truism that can be shown with any excel simulation. The whole point of our ATAC models used for managing our equity sector rotation and absolute return mutual funds and separate accounts is to try to avoid high risk periods through risk rotations that incorporate the behavior of Utilities, and Treasuries.
Being prudent has been punished as risk management failed since QE3 began. It's end should usher back a period where risk matters yet again.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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