The law of one price has been dishonored

There are three extreme happenings that have occurred so far in 2013 which I believe are wildly under appreciated.

The first is the advance in the U.S. stock market relative to inflation expectations.The second is the spike in yields, with investment-grade credit ranking in the top three worst quarters going back 30 years.

The third is the spread of emerging markets to the S&P 500 being the widest its been since 1998 in the absence of a 1998-like event.

Frustrating, indeed, for anyone who tactically trades, although in some ways it’s good to have extremes happen so one can bet on a resync. I have hit the emerging-markets trade over the head numerous times, but I want to attack the mean-reversion thesis from a different angle here.

Some have argued on Twitter that the reason the spread between emerging markets and the U.S. is this wide is indeed due to an event — the event of quantitative easing. Maybe, but if that's the case, then this is some illegal price movement.

The law of one price states that identical goods should carry identical prices if markets are efficient. I am not a believer in efficient markets given the ample evidence to the contrary. However, I do think its safe to say that similar assets should be priced similarly.

The co-movement of foreign-stock ADRs to U.S. markets, co-movement of stocks grouped by sector, and the co-movement of large-capitalization and small-capitalization stocks indicates this is largely how markets work. While none of the components are perfectly correlated, they still do tend to move in unison.

U.S. markets have had a runaway move, and everyone is in love with chasing the trend. Yet, if prices are right, then should not emerging markets react off of the pricing behavior and the message of mufti-national large-cap stocks of developed markets?

Take a look below at the price ratio of the SPDR S&P Emerging Markets ETF GMM, -0.40%  relative to the i Shares MSCI EAFE Index Fund ETF EFA, +0.72% As a reminder, a rising price ratio means the numerator/GMM is outperforming the denominator/EFA. A falling ratio means under performance. For a larger chart, please click here.

This is not just a U.S. QE story. Emerging markets have massively underperformed the markets of non-QE stocks, and are not at ratio support. How does the law of one price apply here?

If developed markets are strong, then should not the factors that affect those stock prices also positively impact stocks in emerging markets? Should not the emerging-market suppliers of developed markets be pulled higher by improved stock market sentiment in the buyers of their goods?

The spread is what is illegal here. And while I fully recognize that irrational markets can get even more irrational, there comes a time when one can feel comfortable in identifying a massive disconnect based on unemotional reasoning and logic. Similar assets priced similarly? Hasn't happened yet. That's exciting.