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Mean Reversion Still Exists

To say this was a big week for mean reversion would be understatement. US Small Caps (IWM), the most loved asset class in the world, traded lower each and every day this week. On the other side of the coin, Emerging Market Equities (EEM), the most hated asset class in the world, closed higher each day. The streak of negative days for IWM and positive days for EEM is now at six consecutive trading days, by far the longest such streak in history. To provide some perspective on just how rare a divergence of this kind is, prior to this streak there had never even been three consecutive trading days where IWM was lower and EEM was higher.

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What is the impetus for this historic divergence in performance? A simple price ratio of small caps to Emerging Markets tells much of the story. Prior to the recent reversal, US small caps had been outperforming Emerging Markets by 75% over the past three years.

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This run has left small caps at or near their highest valuation point in history, depending on which metric you choose. At the same time, Emerging Markets are at the complete opposite end of the spectrum, at the lower end of their historical valuations. While not a short-term indicator, valuation will certainly act as a headwind for US small caps and a tailwind for Emerging Markets in the coming years.

If this is a major turning point in the ratio, there is still plenty of mean reversion to come. Even after the recent reversal, US small caps are still outpacing Emerging Markets by 59% over the the prior three years.

But what about that Emerging Markets crisis, you ask? Judging by the chart below which shows that Emerging Market credit (EMB) has actually been outperforming US High Yield Credit (HYG) this year, the better question might be what about that unexpected US crisis? After all, the nature of black swan events is that they are entirely unpredictable. Given the incessant coverage of the “crisis” in Emerging Markets, it would be difficult to argue that few were expecting an actual crisis to occur.

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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.

 

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