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Michael Gayed: The Crisis Is in US Stocks, Not Emerging Markets


Emerging market debt is clearly indicating that the negative narrative of the crisis is wrong. Watch out for US small caps.

There has been a marked change in tone happening beneath the market's surface since Wednesday of last week. The Dow Jones (INDEXDJX:.DJI) and S&P 500 (INDEXSP:.INX) have been volatile, and emerging market stocks have completely diverged by melting up. Brazil -- represented by the iShares MSCI Brazil Index ETF (NYSEARCA:EWZ) -- in particular has been utterly on fire, and the trade to fade I referenced in my last writing has been long developed, short emerging. Let's review all that made me so obsessed with the disconnect between US markets and BRICs and evaluate what's likely to come next.
(Also see: The Most Crowded Trade to Fade)

For the bulk of 2013, in my various writings and media appearances, I pointed out the relative weakness of emerging market stocks to US markets. I am first and foremost a believer in intermarket relationships and momentum, and while momentum was negative, my argument all along was that the spread differential was unjustified. Not only did emerging market stocks underperform the US market in 2013 like it was 1998 when an actual crisis occurred, but sentiment got so bad that redemptions in the first couple of months in 2014 were more than for all of 2013's months combined.
Valuations also got extreme, nearing levels in the midst of an actual event or crisis. The biggest tell, which no one could possibly dispute, was emerging market debt. After all, if a crisis were really unfolding in emerging economies, their credit markets would be the first to feel it and know about it. That simply never once confirmed the negative narrative that became so pervasive on the equity side. Take a look below at the price ratio of the iShares JPMorgan USD Emerging Markets Bonds ETF (NYSEARCA:EMB) relative to the PIMCO 7-15 Year US Treasury Index Fund (NYSEARCA:TENZ). As a reminder, a rising price ratio means the numerator/EMB is outperforming (up more/down less) the denominator/TENZ. 

So let me get this straight. Emerging market debt is outperforming the "risk-free" investment of Treasuries in what otherwise looks like a "risk-off" environment for US stocks? We're starting to see some historic disconnects happening. To emerge, emerging markets must diverge. The wildly illogical gap in the performance of US stocks to emerging markets in 2013 must resolve itself in an illogical fashion the other way. That means the crisis no one is paying attention to may actually be in US small caps as investors realize they way overshot on the upside at the same time bonds laugh at the Fed's taper.
Mean reversion is back, and it's about to get mean as the "Great Convergence of 2014" takes hold.

Twitter: @pensionpartners
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