“And the day came when the risk to remain tight in a bud was more painful than the risk it took to blossom.†– Anais Nin
Last week several important things began happening from an intermarket standpoint, which make me even more excited for normalcy to come and for the potential of our own strategies to perform strongly. For the past several weeks, I’ve argued that any kind of Quantitative Easing coming from the European Central Bank would result in yields rising. History proves that bond buying from central banks seems to initially result in bond selling by investors, pressuring yields higher. That has indeed been happening, as European and US government yields have been rising, seemingly breaking the unrelenting downtrend that began at the start of the year. This of course assumes inflation expectations not only rise, but are sticky in terms of their uptrend.
Meanwhile, emerging markets and commodities have been sold off aggressively, primarily due to a strengthening dollar and some weaker economic data out of China. US large-caps sold off of on the week, with small-caps down less. One could argue that we are entering a falling stock and bond environment. I believe this is going to end up being wrong with hindsight. The best thing happening right now is Treasuries and defensive sectors going down at a faster pace than broader beta. This is necessary to have happen first before a real “risk-off†period favoring Treasuries and defensive sectors actually begins.
The problem all year has been that Treasuries and defensive sectors have led, but in a correlated way to cyclical equities. Treasuries historically tend to NOT be correlated to stocks, and as shown in the 3rd place award winning paper “An Intermarket Approach to Tactical Risk Rotation†I co-authored with Charlie Bilello, their leadership means stock volatility tends to increase. The problem is stock volatility not only has not increased throughout the year on that signal, but also the duration of ignoring that signal has thrown our own models off which use that and Utilities as part of the risk trigger for rotations.
