“And the day came when the risk to remain tight in a bud was more painful than the risk it took to blossom.” – Anais Nin

Last week several important things began happening from an intermarket standpoint, which make me even more excited for normalcy to come and for the potential of our own strategies to perform strongly. For the past several weeks, I’ve argued that any kind of Quantitative Easing coming from the European Central Bank would result in yields rising. History proves that bond buying from central banks seems to initially result in bond selling by investors, pressuring yields higher. That has indeed been happening, as European and US government yields have been rising, seemingly breaking the unrelenting downtrend that began at the start of the year. This of course assumes inflation expectations not only rise, but are sticky in terms of their uptrend.

Meanwhile, emerging markets and commodities have been sold off aggressively, primarily due to a strengthening dollar and some weaker economic data out of China. US large-caps sold off of on the week, with small-caps down less. One could argue that we are entering a falling stock and bond environment. I believe this is going to end up being wrong with hindsight. The best thing happening right now is Treasuries and defensive sectors going down at a faster pace than broader beta. This is necessary to have happen first before a real “risk-off” period favoring Treasuries and defensive sectors actually begins.

The problem all year has been that Treasuries and defensive sectors have led, but in a correlated way to cyclical equities. Treasuries historically tend to NOT be correlated to stocks, and as shown in the 3rd place award winning paper “An Intermarket Approach to Tactical Risk Rotation” I co-authored with Charlie Bilello, their leadership means stock volatility tends to increase. The problem is stock volatility not only has not increased throughout the year on that signal, but also the duration of ignoring that signal has thrown our own models off which use that and Utilities as part of the risk trigger for rotations.

I am relieved to see this breakdown now in defensive areas, and estimate that any kind of real risk-off pulse likely comes at the end of September to early October, just as the Federal Reserve ends QE. A sell-off in Treasuries and defensive sectors now gives them room to outperform on a real corrective juncture, and may finally give their signaling power a chance to revert to historical accuracy. For our alternative inflation rotation strategies, that means the rotation back to Treasuries can result in the same kind of meaningful outperformance as occurred during the Summer Crash of 2011, and mini-corrections of 2012. For our equity sector beta rotation strategy, that means the potential for meaningful long-only equity outperformance by positioning all-in on Utilities, Consumer Staples, and Healthcare.

The very nature of our strategies is to seek to achieve strong returns largely by being defensive at the right time, given that significant outperformance comes from mitigating the downside rather than aiming for upside. It is why in 2011 and 2012 we were able to achieve very strong returns for our separate account clients, and it is why in those years in dated writings, I myself became known for “calling” big macro up and down moves in various asset classes within weeks of those moves occurring. Both our mutual funds on the alternative and equity side, as well as our separate accounts, have the ability to take advantage of historical cause and effect. We have been living in a small sample in time which from a number of perspectives has been an extreme outlier. The fullness of time, however, rewards historical cause and effect.

Every outlier period comes to an end. I believe we are on the verge of that right now.