“I always liked those moments of epiphany, when you have the next destination.” – Brad Pitt

Large-cap stocks made new all-time highs as emerging markets and small-caps failed to continue rolling momentum, at the same time the US Dollar surged.  Logic would dictate that a strong dollar would negatively impact multi-national large-cap companies relative to more domestic small-cap companies, but we remain in an environment defined by desynched relationships.  With currency wars in full effect between the Yen collapse and the Euro breakdown, magically headline averages seem to not care that earnings will likely be negatively impacted from currency movement.

I say this with sarcasm of course, as recent inflation data continues to prove that bonds have future growth and inflation expectations more right than stocks do.  Next week will prove to be important for the bond/stock relationship.  Yields rose as Mario Draghi announced a form of Quantitative Easing a few weeks ago, against that backdrop US inflation expectations collapsing as measured by the TIP/TENZ ratio.  This is happening at the same time Utilities have underperformed broad market averages, and long duration Treasuries have weakened relative to intermediate.  This is a continuation of non-normal behavior from last year.  Historically, Utilities tend to outperform the stock market and long duration Treasuries tend to outperform intermediate coincident with inflation breakeven movement.

If bond yields begin to fall next week, we are likely closer to a real “risk-off” period characterized by Treasuries meaningfully outperforming the stock market as they did from April-May 2012 (3000 basis points of out-performance in a period of 2 months), and Utilities, Consumer Staples, and Healthcare outperforming cyclical sectors.  In the case of the former for our mutual funds and separate accounts, that means our inflation rotation strategies would rotate out of equities and into Treasuries.  In the case of the latter, that means our beta rotation strategies would rotate out of cyclicals and into defensive sectors while maintaining equity exposure all-in.  Various testing and studies prove that the bulk of returns come primarily from avoiding big declines.  We have yet to experience one such period in equities more broadly.  That will change, and every day we get closer to that happening.

We are inching towards an epiphany that central banks are failing to generate growth and inflation in the context of the trillions of dollars unleashed in the hopes of achieving a more robust economic environment.  The environment is likely more fragile now than ever before since the financial crisis.  This is not hyperbole.  By definition, when complacency is as high as the pre-1987 crash, and when credit spreads are abnormally low, mean reversion becomes the invisible hand.  This does not have to mean a collapse is coming, but rather means that the abnormally high correlations between and across asset classes and sectors must break.  This is welcome news for tactical traders and those who have tested strategies across cycles beyond the small sample in time we all live in.

It is often said that large-cap equities are the last to go.  If that is true this time around, then October and the end of Quantitative Easing will result in a marked regime change beneath the market’s surface.