Divergence of Behaviour

We’ve had an interesting series of divergence recently in the markets.  Specifically, the bad is good trade.  Since QE3 began we’ve become junkies of easy money.  For the past several years the market has traded up on bad economic news because the implication of bad news is that the easy money will continue.  On the other hand the market traded up on good news as well because that meant there would be less talk of inflated price multiples.   So you had an upward skew and that is obvious when looking at essentially any market data over the past two years.

Now we’ve heard a little bit lately about divergence between small caps and large caps or Russell vs Dow Transports for instance.  This is typically a bad sign as a divergence leads to a mean reversion.  At some point the divergence will correct and it can correct by the lower moving higher or the higher moving lower.  The danger is if the Russell is an indicator that the large caps will sell off to come in line with the small caps.  However, the more interesting divergence in my opinion began upon last week’s Q2 initial GDP print.

Here we had a better than expected print yet the market sold off.  A divergence in behaviour.  I expect the reason is now the taper is close to ending the easy money train and inflation is beginning poke its ugly noggin above the water.  These things mean not only is easy money ending but that rates will need to move higher sooner than expected.

I was curious to refresh my memory about given divergences that took place in ’07 and ’08.  We saw the identical divergence between small cap and large cap as well as the divergence between the market beviour and the pundits for market euphoria, which we are seeing today.  Eventually the pundits will also go through a mean reversion.  They do not want to be the last crazy touting everyone to catch the falling knife or buy the dip as they would suggest.  So as in ’08 eventually the last of the pundit euphorians (and what’s great is you can actually see these fools on YouTube caught being foolish back in ’07/’08) came around to accepting that it wasn’t just a dip.

I do think the market will see ups and downs.  But rather than the steady not so random walk up we will again see a not so random walk back down.  Remember the market topped out in ’07 and the bottom was in March ’09.  So the idea that there will be one catastrophic day where the market collapses to its lows will not happen.  It begins with a divergence in market behaviour.  Specifically a divergence from how it has been behaving and how it will behave going forward.  And we saw that inflection point last week.