Hindsight bias makes surprises vanish.
So far, 2014 is behaviorally acting more like the pre-2013/outlier period. Numerous intermarket trends are behaving in a historically observed way based on risk-on/off dynamics. Daily swings in markets have become more accentuated, reminding investors that risk actually does exist beneath the surface. Meanwhile, emerging markets have been getting hit, with China (represented by the iShares FTSE/Xinhua China 25 Index ETF
(NYSEARCA:FXI)) in particular exhibiting the most negative momentum. Gold (represented by the SPDR Gold Trust ETF
(NYSEARCA:GLD)) is getting a safety bid, gold miners (represented by the Market Vectors Gold Miners ETF
(NYSEARCA:GDX)) have been ripping higher, and as I noted before, bonds have been laughing post-taper.
It looks like many things changed after the weak payroll report. The bond market is not treating weakness as an aberration by any means, given that inflation expectations have ticked lower ever since. The much-hyped beginning-of-year allocation into stocks isn’t quite working, and the Fed’s December 2013 tapering is simply giving the market the chance to replace the printing press. With everyone calling for a “rising rate environment” completely disregarding inflation expectations, perhaps the ultimate shocker would be for a risk-off period ahead. My own firm's models are beginning to sense a bit of a deflation pulse.
What if the real story is money rotating back to bonds away from US stocks after last year’s huge move? With much of the advance based on P/E expansion, any kind of questioning by the market about future earnings growth might be enough of a catalyst to break down and overwhelm the rising-rate-environment belief, at least in the near-term.
Take a look below at the price ratio of the PIMCO 7-15 Year US Treasury Index ETF
(NYSEARCA:TENZ) relative to the S&P 500 ETF
(NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/TENZ is outperforming (up more/down less) the denominator/SPY.
It has been a long time since Treasuries outperformed stocks, and many intermarket correlations experienced abnormal changes as the Fed first introduced the term “taper.” Now, if indeed the market questions demand-pull inflation, and/or some exogenous shock actually does come from emerging markets (not my base case), why not consider bonds for a trade? What if the market soon realizes that QE has failed to juice reflation, and begins considering that fragility remains elevated with no Gray-Haired Bears even attempting to question the Nouveaux Bulls’ thesis?
Given where we are in the election cycle, this may be a considerably less optimistic year than some might otherwise think. The two most bombed-out trades are long-duration bonds and emerging market stocks. Both can have significant moves ahead, but for now it looks like Treasuries may have their turn to advance, or at least outperform, US equities. If the TENZ/SPY ratio does trend higher from here, then the great rotation may ultimately be back to fixed income.
No positions in stocks mentioned.
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