“Reality is wrong. Dreams are for real.” – Tupac Shakur

Last week was an important one from the standpoint of many intermarket relationships. Homebuilder stocks continued to badly underperform the S&P 500 as housing starts missed by the most since 2008. Long duration Treasuries, after their earlier decline in the first week of July, whipsawed to new highs on the year. US small-caps continued their complete relative collapse (price ratio against the S&P 500 below) which came out of nowhere in July and was extremely severe in speed and magnitude, serving as a reminder of the reality that markets can take away performance in the blink of an eye.

And, of course, the VIX spiked on Thursday’s news of the Malaysian airplane tragedy and ground offensive by Israel, before ultimately falling the day after. Generally, extreme one day spikes in volatility tend to reverse the next day, but of course does not necessarily mean future volatility will remain at low levels. Perhaps most importantly last week, however was the behavior of non-developed countries. Emerging markets took a sizeable hit Thursday, only to rebound strongly Friday and still perform well on the week. A meaningful change is taking place, which the bottom graph shows is important to watch for. A moment of reality is coming for emerging market bears, given that emerging market debt is finally outperforming US junk debt.

If credit leads equities, it stands to reason that emerging market stocks should begin to meaningfully outperform the US, as they continue to broadly price in a crisis and severe slowdown relative to developed economies. For those looking for the next major move, this could be a dream scenario which plays out. Political change has come to India, and may come to Brazil. Those two alone might be enough to cause funds to flow in EM more broadly, which is where our absolute return inflation rotation strategy are currently positioned given near-term momentum.

All of this, of course, assumes momentum continues, and that conditions still favor equities over bonds which our models week-over-week tell us. As to our beta rotation sector strategy, energy remains the overweight, consistent with momentum in emerging markets and global late-cycle plays leading. Financials continue to be underweighted as banks overseas perform poorly, and the yield curve flattens.

The coming weeks and months will be a busy for me personally, as I travel the country to present our award winning papers, mutual funds, and separate accounts to advisors and members of the CFA Institute and Market Technicians Association. Those located in Colorado or in Minneapolis who might be interested in attending my formal presentations on predicting corrections and volatility, please feel free to reply and let me know.