“Words have a life of their own. There is no telling what they will do. Within a matter of days, they can even turn turtle and mean the opposite.” – Craig Brown
A volatile week for equity investors as small-cap stocks closed nicely positive, large-caps languished, the VIX popped and dropped, and Treasury yields collapsed, only to rise following the largest one day decline in rates since 2011. Much of the intermarket movement thus far has been reminiscent of the Summer Crash of 2011, though not as violent nor severe yet.
While we will only know with hindsight if the bottom is in for both Treasury yields and stocks, from a contrarian perspective it is interesting that no one I’ve interacted with seems to think it can get worse. At a presentation on our award winning papers to an advisory office in DC, I received questions about small-caps, as many seemed to want to begin putting money to work there. I found this curious, as this also confirmed the idea that more people seem to be thinking that volatility is over and stocks now will resume their trend higher.
European bond yields in problem countries, notably Greece, Spain, and Italy, rose against German Bunds which remain strong. Credit spread widening on the sovereign level looks eerily like 2011, and may only just be getting started. Credit spreads in the US have also been widening, when looking at the behavior of Junk Debt and AAA bonds. This may have been why Bullard on Thursday expressed the opinion that the Fed should slow down tapering, and also why Yellen reaffirmed her faith in the economic recovery. Bullard’s QE bluff was interpreted by investors as meaning more QE may come should global growth worsen due to deflationary pressure overseas. Somehow, the market still fails to admit to itself that no amount of QE has been shown to reverse these deflationary trends. Like a Pavlovian dog hearing the sound of a bell, however, the specter of more QE means credit spread narrowing and equity uptrends.
I have my doubts. Inflation expectations, as shown by the TIP/TENZ ratio, now sits at support. If they break down from there, the Fed may be in trouble, as it suggests domestic deflationary fears would be rising. Small-caps could continue to outperform purely because of how oversold they are relative to large-caps this year, but there have been plenty of instances historically where equities fall even though small-caps are outperforming into the decline. Credit spreads on both the sovereign level and in the corporate space are the canaries in the coal mine. A continuation of their widening means the current correction is likely not over, could result in a panic, and bring a thematic change to how investors perceive not only the future, but central bank power to direct it. Should that occur, that would be the real correction to be afraid of.
For us, we will continue to rotate around equities and Treasuries in our inflation rotation alternative strategies, and rotate around high beta and low beta sectors in our beta rotation approach, both used in our mutual funds and separate accounts. Our approach is quantitative in nature, and the conditions have clearly changed given correlation breakdowns all over the place, all of which are healthy and revert trends to historical cause and effect observed in large data, beyond the small sample of time we all live in. The Fall Epiphany has thus far treated our strategies well, and a continuation of this is likely. With many of our competitors in the alternative space suffering severe losses, we continue to be energized by the current environment, and believe that the top in buy and hold likely means the bottom for tactical rotations.
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
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.