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Jeff Saut has turned a bit more cautious in his latest strategy note, but isn’t quite certain where the market is heading next.  He has laid out two potential outcomes for the market and depending on your current outlook, how to play each:

As our friends at the celebrated GaveKal organization deduce, there are basically two options confronting the U.S. equity markets; and, the valuation disparities between the two have rarely been so great.

Option Number 1) “Global growth is just extremely strong and investors remain far too defensively positioned. This would explain the very sharp rally in cyclicals in recent weeks, the rebound in shipping, ports, logistics, materials etc. Of course, if global growth is now much stronger than most expect, a ‘bad cop’ will at some point have to show up at the party to tell the hosts to keep the volume down. Right now, the G7 central banks seem most unlikely to fulfill that role, focused as they are on preventing another Japan. In our view, this means that the ‘bad cop’ might have to be the long end of the bond market, though interestingly the yield curve is already about as steep as it has been in 20 years.”

Option Number 2) “Markets in recent weeks have just been running on fumes, driven by year end window dressing/new year repositioning. We should thus be wary of reading too much into market signals. In fact, the effort to catch up to recently winning trades (i.e., to drive deep cyclicals aggressively higher) may now be stalling. In that regard, (the) pullback in commodities and equity markets following China’s (interest rate) announcement(s) is interesting.”

While we too have been cheerleaders since the March 2009 “lows,” as we entered the new year we have become more cautious, but not bearish. Like GaveKal, the two options present a strategy quandary. If the central banks start to provide less liquidity, or the U.S. dollar continues to strengthen, or China has begun a monetary tightening cycle, then option 2 is likely the right strategy, suggesting participants overweight technology, healthcare, consumer staples, and select emerging and frontier markets. However, if option 1 remains in force, deep cyclicals, transports, materials, energy, and emerging/frontier markets should be the vehicles of portfolio outperformance. Interestingly, emerging and frontier markets seem to be the winners no matter which option plays, although even here we are cautious.