Stock-market crash or mini-correction?

http://www.marketwatch.com/story/crash-or-mini-correction-2012-11-15?link=MW_Nav_TD

Nov. 15, 2012, 11:14 a.m. EST

245 Comments

Share

new

Portfolio Relevance

LEARN MORE

About Michael A. Gayed

Michael A. Gayed, CFA, is chief investment strategist and co-portfolio manager at Pension Partners, LLC., an investment advisor which manages a mutual fund and separate accounts according to its ATAC (Accelerated Time and Capital) strategies focused on inflation rotation. Prior to this role, Gayed served as a portfolio manager for a large international investment group, trading long/short investment ideas in an effort to capture excess returns. From 2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered investment advisory firm that managed equity portfolios for large institutional clients. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube youtube.com/pensionpartners.

Michael's latest posts

• The Fed fights itself
• Bonds return as sky falls
• QE3 tops the euro as deflation pulse beats

View all

The trading deck is powered by

By Michael A. Gayed

The decline in the S&P 500 and worldwide equities has been unrelenting so far this month, as the corrective risks I highlighted Oct. 1 and in every single writing since then have abruptly ended the reflation trade post QE3. On Nov. 5 I began pounding the table to " forget the elections " on the stark warning price was signaling through the return of the deflation pulse. Our ATAC models used for managing our mutual fund and separate accounts have sensed this for weeks, keeping the portfolios we manage completely out of the stock market.

Very suddenly, it feels like we are in the midst of a perfect storm given European austerity protests and public disputes over how to handle Greece, the threat of tax hikes under the Obama administration on dividends and capital gains, and the question of whether the Fed is " fighting itself ," as I speculated in my last writing in terms of actually causing deflation expectations to rise by removing a sense of urgency for money to move throughout the economy. Indeed, one could argue that the Fed has destroyed the ultimate weapon of all — the element of surprise.

"Darn the wheel of the world! Why must it continually turn over? Where is the reverse gear?"

—Jack London

This is not just a U.S. story. Certainly the fiscal cliff, which has been known for some time as a risk to the markets, is causing distortions within intermarket trends to take place. However, Germany appears to be in the early stages of weakening at a faster pace than the U.S. China and emerging markets, which have otherwise been strong, appear to be breaking down and may be vulnerable to another period of lagging.

The argument that money is selling to lock in lower capital gains is not the whole story here. The assumption in that is that there are actual capital gains to sell. Most hedge funds are hugely underperforming due to the earlier lack of belief in the reflation trade, meaning that there aren't really gains to sell for most active traders to begin with, the exception, of course, being stocks like Apple AAPL -0.24%  which have erased in market cap alone months worth of the Fed's QE3 stimulus.

With most market averages now below their respective 200-day moving averages, and bond yields for most durations under the Fed's stated inflation target of 2%, the question becomes how much worse it gets.

I have likened price action over the past several weeks to the lead-up to the May mini-correction . I called for in early April before the June 4 melt-up low . Part of the reason I called for a mini-correction back then was the "Bear Paradox" — the idea that it is hard for stocks to collapse because a deep decline makes dividend yields rise while bond yields are already at panic lows, making stocks at a certain point a better income play than fixed income.

I maintain that the Bear Paradox likely means much deeper declines in equities are unlikely. Having said that, what would dramatically alter the odds of a collapse in equities resulting in a crash? Could a Summer Crash of 2011-like move, which I called for in June of last year , happen again?

The answer depends entirely on if a sudden and sharp widening of credit spreads takes place. Take a look below at the price ratio of the SPDR Barclays High Yield Bond ETF JNK +0.10%  relative to the Vanguard Total Bond Market ETF BND -0.01% . As a reminder, a rising price ratio means the numerator/JNK is outperforming (up more/down less) the denominator/BND. For a chart, visit https://twitter.com/pensionpartners/status/268933082353123328/photo/1 .

The trend in the ratio is one way of tracking if credit spreads are narrowing (an uptrend), or widening (a downtrend). In my last Lead-Lag Report , I specifically highlighted the risk that credit spreads could sharply widen in the coming days.

Note the highlighted areas, which warned of a momentary period of crash risk back in late-May of this year, and during the Summer Crash of 2011.

I highly recommend viewing my CNBC interview back on May 23 discussing what was happening then in credit markets within the context of crash risk and compare that period and what I said then and to the way price has behaved recently.

Credit spreads have indeed been widening, but so far the decline has not been accelerated. Should a very sharp period of weakness in JNK relative to BND occur in the days ahead, then the Bear Paradox idea gets thrown out the window. So far this does not seem to be happening just yet, but if there is one inter-market trend to watch going forward, this is it.

Remember that it is not as simple as saying "credit leads equities" — it is credit spreads which are crucial. It is not just what is happening to market averages that matter, but what is happening within the markets themselves. A breakdown in credit spreads would be a massive warning that the odds of a collapse are rising.

Amazing how in the blink of an eye, the world can look so different than it did mid-September, isn't it?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.