Following last week's return of volatility and Monday's expected follow-through, we issued our weekly Sector Note on Tuesday.
At a point of near-record overvaluation, the market's monetary underpinnings are beginning to change, coincident with a maturing business cycle. The unprecedented duration of market distortions provides for latent volatility to re-emerge sharply.
For nearly a decade, we have been concerned with the distortive impact of monetary policy on the markets. Currently, our four measures of long-term market valuation are in their highest quintiles, levels associated with negative 1, 5 and 10 year returns. While this is problematic and requires investors to adjust their way of thinking about risk management, equities remain the only game in town for a majority of investors until interest rates begin to normalize. This does not preclude markets correcting, however.
The reliability of intermarket analysis is dependent on an absence of external distortion. Recall that intermarket relationships broke down with currency intervention following the Thai Baht crisis in 1997 and liquidity intervention following the financial crisis in 2008. As the impact of QE intervention subsides, we look to intermarket relationships reasserting themselves. Both inflationary and deflationary signals are present, with a recent tilt towards deflation.
Rarely do economic indicators impact the equity markets anymore, however Friday’s employment report appears to have added a last straw to a number of over-committed trading areas, including oil having its best 1 week move in years (USO +9.3%). UST yields bounced (TLT-1.8%) in response to the perceived higher likelihood that the Fed would raise rates. In similar fashion, Utilities fell sharply (XLU -4.1%) and broke 46.79 support, precious metals fell sharply (DBP -2.6%) and broke 38.75 support.