originally published March 10, 2015
I am sitting here in the balcony seats at the Napa City Winery. Somehow, my peripatetic social life has dragged me down here to listen to a Hispanic rap group. That's right, you heard it correctly. A Hispanic rap group.
It is midnight.
The sound is so loud that it is vibrating through my chest. So I have withdrawn into my own inner silence to contemplate what the hell happened in the financial markets on Friday.
Most modern hedge funds are constructed using a series of complex correlations between asset classes which are back tested years, if not decades.
When stocks go up (NYSEARCA:SPY), bonds (NYSEARCA:TLT) are supposed to go down, as corporate America profits from the lower cost of money. When stocks go down, gold (NYSEARCA:GLD) is supposed to rally, as traders flee from risk. When bonds collapse, the dollar is weak, as foreign investors repatriate the proceeds of their sales.
And so on, and so on.
Except on Friday, none of this worked. Everything went down in unison. Only the dollar rose. It was that simple. You could hear the models blowing up like fireworks on the Fourth of July (or Guy Fawkes Day, whatever your persuasion).
To see the market trade this badly on such great news as the blockbuster February nonfarm payroll of 395,000 was really quite amazing. It makes no sense, but it is there, and therefore, I am gone.
Whenever I don't understand what is going on, I get out. You should too.
I was never one to argue with Mr. Market. So I have moved to a 100% cash position, a circumstance, which for me, is as rare as a dodo bird.
Did the world go mad when I wasn't looking?
Which leaves us to contemplate what the markets are trying to tell us deaf traders.
When you see illogical, irrational, unpredictable market behavior like this, it is evidence that the market is changing. But in which way? Let us consider five possibilities.
1) The Fed is Raising Rates in June. It is amazing how much complacency there is out there about the coming hike in interest rates, the first in a decade. The talking heads will tell you that it is well telegraphed, fully discounted, and in the market. But when the momentous event actually occurs, just watch. Traders will run around like chicks with their heads cut off.
It is not in the market.
2) The market is topping out. This is the most frightening prospect for most investors, as the memories of the Great Crash are so recent. Unfortunately, it has also been predicted annually for the last seven years. If anything, the global economy is getting stronger, not weaker, now that Euro QE is finally kicking in.
This new virility will enable Europe, China, and Japan to rejoin the global economy after a prolonged period of absence. US economic growth should catapult from 2.5% to 3% this year. That's what Friday's 5.5% headline unemployment rate was shouting at us, the closest to full employment that we have been since 2005.
3) Money is Shifting Out of the US and into Europe. It is only natural that investors want to reallocate capital out of markets where QE is ending, like the US, and into markets where it is beginning, such as Europe. Those who have been mercilessly beaten for diversifying internationally for the last seven years, are now, at long last, getting rewarded. Suddenly, learning all those exotic foreign languages and strange customs is getting you more than a nice table at an ethnic restaurant.
The markets certainly believe this, with the Wisdom Tree International Hedged Equity ETF (NYSEARCA:HEDJ) up an impressive 20% in 2015, compared to a feeble 0% for the S&P 500 . Nothing persuades like performance.
4) The Seasonal Period of Equity Strength is Ending. Remember "Sell in May, and go away"? That looming deadline is only two months off. Some four of the six months of seasonal equity strength is behind us.
5) The Strong Dollar is Finally Starting to Hurt. After a 34% depreciation of the Euro against the US dollar over the past seven years, the deflationary impacts are finally taking their toll. Global multinationals are feeling the heat the most, mid caps less so. At last, I can afford my extravagant European vacations!
If the dollar is the driver, can we expect any respite? Only if the Federal Reserve cancels all interest rate hikes for the foreseeable future. In other words, fat chance.
Parity against the Euro, here we come!
All of this inspires me to exercise greater than usual amounts of self-discipline and risk control. With any luck, I'll be all cash going into the next meltdown. That is worth paying a premium for in terms of opportunity cost.
Hey, even a broken clock is right twice a day, occasionally a blind squirrel finds an acorn and if you fire buckshot long enough, eventually you are going to hit a barn.
Well, the band has just completed its grand finale, wading into the middle of the crowd for a giant selfy. My ears will be ringing for days.
Now, for my next newsletter…