In early October 2014, we noted the momentum reversal of Low Quality stocks and a few signs of the likelihood of transitioning to another phase of the quality cycle. The official numbers of Q4 have confirmed this.

We are nothing if not contrarians, but have also highlighted the hazards of “knee-jerk” contrarianism—in which investors are instinctively drawn to the asset, sector, or stock that is down the most in price in the recent past.

The collapse in oil prices has brought down inflation expectations dramatically. Inflation will likely be the single most important driver of interest rates in the next 6-12 months.

Perhaps the most important is the credit channel; the substantial curve flattening that happened recently in anticipation of the Fed hike next year has made lending standards tighter for small businesses.

Amidst the Energy sector tumult, the Oil & Gas Refining & Marketing group is the exception.

We don’t yet know whether our second-half adjustments to equity exposure will prove premature or just plain wrong. Our tactical funds remain positioned with below-average net equity exposure of about 50%.

Market gains have been less broad than in 2012 and 2013; market direction and leadership have been mismatched; and quantitative factors have been choppy.

The median S&P 500 stock is now expensive enough that we’re able to estimate its potential downside to prior bull market highs! Based on an average of four valuation measures, the median stock needs to drop about –11% to match the typical valuations at the eve of a cyclical bear market.

Six of the seven factor categories we track have turned in positive performance so far in 2014; Value is the exception. Lost in the numbers is that most of the value has come from the short quintiles, so it has been hard for managers to take advantage of this trend.

We remain positioned with below-average net equity exposure in tactical portfolios for now. We’re inclined to think there may be more trouble ahead for the stock market.

The renewed embrace of risk hasn’t extended to the sector level. After resisting decline in late September through mid-October, defensive sectors have matched the rebound in Cyclicals, almost point for point.

Investors are becoming more and more comfortable buying stock market dips. This is obviously latecycle behavior, but sentiment measures alone aren’t enough to tell us how late.

The sell-off in risky assets in early October promptly led to expectations of a more dovish Fed.

The recent strength in the dollar coincided with a spike in volatility and weakness in risky assets, but the relationship over the last couple years has been tenuous at best.

Up/Down Earnings: Best One Month Reading Since Q2 2011

Small Cap Premium Spikes Back To 20%

September’s small S&P 500 loss of less than 2% disguised a significant breakdown in the “average stock.” In fact, the S&P 500 has been tougher to beat than at any time since the Tech Bubble.

With the Fed mulling over a rate increase, investors may have already started to avoid companies with excess leverage. Unfortunately, Small Caps, on average, are in this camp.

During a tumultuous Q3, High Quality stocks proved to be resilient, losing only 2.0% compared to Low Quality stocks’ 7.5% loss in Q3. Low Quality stocks’ prior momentum seems to have broken down, especially in September when they slid by 7.1% for the month.

Latest MTI calculation deteriorated to Negative (based on data for the week ended October 3rd). We expect further significant losses in the stock market near term and have cut net equity exposure in Core and Global asset allocation portfolios to 40%.