“There comes a time in the affairs of man when he must take the bull by the tail and face the situation.” – W. C. Fields
Stocks are not hitting new highs. Only a particular index, the S&P 500, has that distinction. When reviewing sentiment surveys this weekend, I am struck by how extreme optimism has been relative to history when in fact the average stock is flat to down this year based purely on breadth. Small-caps have not fared well in a way that suggests the optimism is justified. Neither have emerging markets nor Europe. As I continue traveling, meeting with advisors and presenting to various CFA and MTA Chapters, the frustration is universally the same. Most moderate asset allocation portfolios which advisors put together and which are meant to be diversified are up 5% this year. Good, but not S&P 500 great. Not a single advisor I’ve spoken with has said their clients want less S&P 500, but more.
Yet, more of something against the backdrop of heightening risks will only be seen as dangerous with hindsight, and make no mistake that risks are rising everywhere. Junk Debt, a tremendous source of yield chasing, has fared poorly relative to most other areas of the investable landscape as credit spreads widen because of potential looming defaults in the Energy space. Energy stocks? A historic collapse and period of underperformance is underway, with Friday seeing a shocking spread between the sector imploding and the S&P 500. The meme is very wrong in thinking that lower Oil is bullish. Certain state budgets rely on a minimum levels of Oil, and to the extent that it creates bankruptcies in shale plays, economic growth from that alone could sputter. Yes we all should want lower gas prices, but not in a precipitous way if it risks instability in larger areas of the economy. If the collapse in Oil were bullish, US domestic small-cap stocks should be surging relative to large-caps. That is not happening.
This dynamic alone has kept bond yields low. Traditional intermarket analysis suggests that as commodity prices fall, yields fall because of less cost push inflationary pressure. The Federal Reserve will have a hard time raising rates if the yield curve keeps flattening, and we are nearing a point where something major likely will happen in markets. From an asset allocation standpoint, diversification only happens by mixing uncorrelated assets that move off of different factors. The correlation between Treasuries and the S&P 500 has been incredibly high because of the belief that lower rates are good for stocks, rather than a reflection of faltering growth and inflation expectations which is historically exactly what falling yields are a reflection of. The lower yields go, the more the US and Europe look like Japan, and the more likely the correlation between the two cracks in a powerful way. This needs to happen for risk managers to succeed in mitigating tail risk, and also needs to happen to justify diversification.
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