“I’m sorry, if you were right, I’d agree with you.†– Robin Williams
While January ended with a thud in risk-taking and surging defensive sectors and Treasuries, February began with the exact opposite occurring. Yields rose at the same time Utilities were slammed despite on-going fears over Greece. As we get closer to the European Central Bank actually beginning its bond buying through Quantitative Easing, it appears that fixed income investments may finally be vulnerable and rates may rise, at least in the near-term. Historically, the beginning stages of Quantitative Easing actually end up being bond bearish, and with negative yields seemingly coming up out of nowhere in many parts of the globe, the broken clock of “rising rates†may be right to some degree.
Counter-trend trades do happen, and the unrelenting flattening nature of yields may from a contrarian standpoint be worth betting against. This would imply large-caps hold their ground as laggards turn to leaders, particularly in the small-cap, emerging market, and cyclical sector space. The severe breakdown in Utilities last week, the magnitude of which hasn’t been seen since early 2009, seems to suggest risk-seeking behavior is about to return. It is important to note, however, is that this time around risk-seeking behavior is being confirmed by defensive weakness. The fundamental problem for tactical rotation strategies has been an abnormally high correlation between strong equity markets and strong defensive areas, characteristic of the last year and a half. Recent correlations appear to be reverting back to normal, indicating that risk-on means actual risk does better.
Certainly a big correction is out there somewhere, and every day that goes by we get closer to it. Historically, Utilities and Treasuries tend to lead before that occurs. The breakdown last week in these two areas puts a potential period of strength back in them sometime around March. For our alternative inflation and beta rotation mutual funds and separate accounts, following a strong January where being defensive paid off well, last week was enough to push our models back into a more aggressive posture. Whether this holds or not remains to be seen, but the bigger focus remains the relationship of defensive to aggressive areas of the investable landscape. If a more traditional aggressive posture is coming and defensive areas lag, then the market environment will have changed. This is crucial for our risk rotation approach to money management.
