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Michael Gayed: Deflation Is Underweighted


The deflation trade is underweighted in portfolios. Gray-haired bears look set to return.

Major cracks happen in stock markets when they are preceded by complacency, a sense of entitlement, the illusion of stability, and leverage.

My friend and fellow Minyanville contributor Duncan Parker and I were going back and forth on Twitter, and he used a line that I thought was particularly interesting. "Deflation is underweighted," was the gist of the 148-character discussion and is worth addressing in a formal writing. In recent articles here on Minyanville, I've noted the very real potential for a risk-off period to come and a rotation back into bonds, despite the "rising rate environment" meme. Payroll data freaked Treasuries out by being weak and caused an aggressive reversal in yields. Earnings remain lackluster, and complacency is off the charts. Emerging markets are the birdie. The real problem remains the deflation pulse.

Risk management still matters, and make no mistake about it that this move down looks early and is consistent in terms of risk-off behavior. Last year was an outlier and threw many intermarket trends out of whack. This year so far looks far more normal in terms of historical cause and effect. Those who recall my major (correct) macro up and down calls in 2011 and 2012 may see a more familiar market. A trap down can open at any time if stocks come to the realization that the bond market is screaming, as credit spreads begin widening, and defensive sectors lead.

Why do I say this is early? Take a look below at the price ratio of the Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP) relative to the SPDR S&P 500 ETF (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator (XLP) is outperforming (up more/down less) the denominator (SPY). Note that low beta/defensive sectors like consumer staples are showing renewed strength, and in this case, are bouncing off support.

There is a duration element to leading and lagging sectors. My firm's own ATAC models used for managing our mutual fund and separate accounts positioned just last week into long-duration bonds and are firmly in deflation pulse mode. If defensiveness is just getting started, as the above ratio indicates, then this could be a rough first quarter. Markets are much more interesting when gray-haired bears come growling. Honey badger needs to be real careful of a resyncing of historical correlations…

Twitter: @pensionpartners
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