"The human mind can bear plenty of reality but not too much intermittent gloom." - Margaret Drabble
Stocks fell last week on the heels of a number of major macro headlines both domestically and abroad. While much of the attention was focused on the elections and Obama winning a second term, perhaps equally as important was some of the news coming out of Europe. Mario Draghi of the ECB warned that Germany's economy was starting to feel the strong effects of the Eurozone slowdown, sending the German DAX index down MORE than the U.S. S&P 500 for the week. Images of protesters in Greece coming out in full force during the recent parliamentary austerity vote were highly reminiscent of those that occurred prior to the May 6, 2010 Flash Crash.
As those who have been tracking our work for the past several months know, however, we have been hammering the idea that corrective risks were rising since late September given the message of price. We have been extraordinarily bullish on stocks since the beginning of the year (which was the right playbook to go by), but the price action following the Fed's announcement of Quantitative Easing 3 has been disturbing.
What has bothered Ed Dempsey and I for several weeks has been the behavior of the bond market. While everyone focused on Apple's (AAPL) "bear market", few have been openly asking the question of why 30 year Treasuries were unable to break above the panic 3% level post QE3. This week, Treasuries tumbled in yield, sending the 30 year yield back to 2.74% and the 10 year back to 1.61. Yes - the bond market is very afraid. While Bond returns in Skyfall, bonds returned as sky falls.
But is the bond market afraid of the "Fiscal Cliff?" While the Fiscal Cliff certainly has grabbed the headlines, price does not seem overly concerned based on that so far. Small-cap stocks tend to be more sensitive to the domestic economy than large-cap stocks which derive revenue overseas. The fact that small-caps (IWM) have not meaningfully underperformed large-caps (SPY) in the most recent few weeks suggests that the market to some extent believes the risks of going over the Fiscal Cliff are not as high as they seem to be in the media. Rather, it appears we are in the midst of a global deflation pulse hurting risk assets worldwide.
Our ATAC models used for managing our mutual fund and separate accounts remains in bonds and has continued to benefit from this most recent correction in stocks. I have stated in recent writings that this looks very similar to the May mini-correction of earlier this year, and that the extent of deterioration has lasted for longer than I expected. However, further downside may be limited as the "bear paradox" returns. (I highly recommend viewing our latest ATAC Market Take video titled "Dow Below 13K, Now Which Way" on our homepage to see Ed Dempsey discussing this and much more.)
What happens next? Will stocks be able to turn around and are new-all time highs still possible (the Fall Catalyst)? I will be addressing this next week. Clearly the reflation theme has been put on hold, with the Fed's QE3 ironically marking the top in the idea with hindsight after being the correct way to think about markets in the face of the negative narrative since January. The deflation pulse has been beating for nearly two months now, and unless conditions improve, we remain defensive.
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.