“Don’t wait until you’re in a crisis to come up with a crisis plan.” – Phil McGraw

Following a second nasty week for stocks, the media is now beginning to ask if we are on the verge of a recession. Small-cap stocks have entered “bear” territory after a 20+% drop off the highs. Recession or not? Bear market just starting, or simply on-going?

The evidence is mounting that the fundamental problem all along has been one of historic divergences within markets. Simply looking at headline averages belies this fact. All along, bear market behavior has been happening beneath the surface. All along, Utilities, Treasuries, and low beta stocks have continuously outperformed as small-caps, commodities, and emerging markets were in an on-going secular decline.

Those very same headline averages, over the last 10 trading days, had their worst first two weeks to start the year in history going back to 1928. When divergences get extreme, the beginning of the convergence is equally as violent. It is clear now with hindsight that the extent of the divergence headline averages have had with everything else is precisely why active strategies of every stripe, whether alternative, unconstrained, or sector wise have had such a hard time. When divergences persist for a long period of time, fragility increases.

The good news is that finally market behavior is respecting history and this should result in a massive shift away from passive return management to active opportunities. The bad news is that for asset allocators who have relied on passive indexing, this could get a lot worse before it gets better. The dilemma here is that unlike 2008 which was driven by a banking crisis, the Fed cannot bail out the Energy sector. The Fed can’t also suddenly lower rates after having just raised them as that would result in a complete loss of credibility by the marketplace. It turns out, the deflation pulse is much more severe than originally thought.

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