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Michael Gayed: The Most Crowded Trade to Fade


Emerging markets have been the popular way to hedge equities. That may be about to change.

There's been some interesting behavior the last two days within equities. High-momentum trades, most notably biotech, have, for lack of a better term, collapsed. High beta small-caps? Significantly underperforming. Momentum is breaking, and value may be beginning to replace it. US stocks are not in the value camp. Nor are Japan or Europe. The cheapest area of the equity landscape far and away is emerging markets, which has been like a rock amidst market volatility. The most crowded trade of all is long US high beta, and short the BRICs. Emerging markets became the source of hedging, while the US became the bastion for investments.
I have been arguing in the last few weeks that a setup is very much there for a melt-up to come, given fund outflows nearing what appears to be a crescendo, crisis valuations, and an incredibly ingrained negative narrative that rising rates are bad. History, of course, proves this assertion to be false, since US rates rose all throughout 2003-2007 as emerging economies ripped higher. Never mind that, though. Emerging market debt has been incredibly strong despite huge outflows. Bad news in China? Rally. Brazil credit downgrade? Rally. Things are changing.
Sure, I've been on this theme for a while. Why is it different this time? The chart below says it all. Take a look at the price ratio of the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) relative to the Russell 2000 ETF (NYSEARCA:IWM). As a reminder, a rising price ratio means the numerator/EEM is outperforming (up more/down less) the denominator/IWM. 

The fact that this is happening despite concerns over Russia and in the face of slowing economic data coming from China is important. With the first quarter coming to an end, spread traders who have been shorting emerging markets may have to cover aggressively if a melt-up is about to occur when everyone least expects it.  A second-quarter move seems very likely now.  My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual fund and separate accounts look ready to take another bite in the trade very, very soon with a bit more confirmation.
Whatever happened to buy low, sell high?

Twitter: @pensionpartners
No positions in stocks mentioned.

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