ATAC Week in Review: The Real Correction to Come

“Words have a life of their own. There is no telling what they will do. Within a matter of days, they can even turn turtle and mean the opposite.” – Craig Brown

A volatile week for equity investors as small-cap stocks closed nicely positive, large-caps languished, the VIX popped and dropped, and Treasury yields collapsed, only to rise following the largest one day decline in rates since 2011.  Much of the intermarket movement thus far has been reminiscent of the Summer Crash of 2011, though not as violent nor severe yet.

While we will only know with hindsight if the bottom is in for both Treasury yields and stocks, from a contrarian perspective it is interesting that no one I’ve interacted with seems to think it can get worse.  At a presentation on our award winning papers to an advisory office in DC, I received questions about small-caps, as many seemed to want to begin putting money to work there.  I found this curious, as this also confirmed the idea that more people seem to be thinking that volatility is over and stocks now will resume their trend higher.

European bond yields in problem countries, notably Greece, Spain, and Italy, rose against German Bunds which remain strong.  Credit spread widening on the sovereign level looks eerily like 2011, and may only just be getting started.  Credit spreads in the US have also been widening, when looking at the behavior of Junk Debt and AAA bonds.  This may have been why Bullard on Thursday expressed the opinion that the Fed should slow down tapering, and also why Yellen reaffirmed her faith in the economic recovery.  Bullard’s QE bluff was interpreted by investors as meaning more QE may come should global growth worsen due to deflationary pressure overseas.  Somehow, the market still fails to admit to itself that no amount of QE has been shown to reverse these deflationary trends.  Like a Pavlovian dog hearing the sound of a bell, however, the specter of more QE means credit spread narrowing and equity uptrends.

I have my doubts.  Inflation expectations, as shown by the TIP/TENZ ratio, now sits at support.  If they break down from there, the Fed may be in trouble, as it suggests domestic deflationary fears would be rising.  Small-caps could continue to outperform purely because of how oversold they are relative to large-caps this year, but there have been plenty of instances historically where equities fall even though small-caps are outperforming into the decline.  Credit spreads on both the sovereign level and in the corporate space are the canaries in the coal mine.  A continuation of their widening means the current correction is likely not over, could result in a panic, and bring a thematic change to how investors perceive not only the future, but central bank power to direct it.  Should that occur, that would be the real correction to be afraid of.

For us, we will continue to rotate around equities and Treasuries in our inflation rotation alternative strategies, and rotate around high beta and low beta sectors in our beta rotation approach, both used in our mutual funds and separate accounts.  Our approach is quantitative in nature, and the conditions have clearly changed given correlation breakdowns all over the place, all of which are healthy and revert trends to historical cause and effect observed in large data, beyond the small sample of time we all live in.  The Fall Epiphany has thus far treated our strategies well, and a continuation of this is likely.  With many of our competitors in the alternative space suffering severe losses, we continue to be energized by the current environment, and believe that the top in buy and hold likely means the bottom for tactical rotations.

Sincerely,
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
Twitter: @pensionpartners

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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ATAC Week in Review: Everyone is a Weak Hand

“The one fact pertaining to all conditions is that they will change.” – Charles H. Dow, 1900

Well then – that’s one way to prove that conditions have changed.

You want to see the NASDAQ (QQQ) go down big? Revisit Tuesday. Want to watch the S&P 500 (SPY) go up huge? Revisit Wednesday (which sucked a lot of the “buy the dip” crowd). Want to watch the Russell 2000 (IWM) give it all back? Revisit Thursday. Want to watch markets go up, down, up, and then collapse by the close? Revisit Friday.

It has been my contention for the past several weeks that a Fall Epiphany was coming for markets, where risk mattered, and stocks would finally begin to price in the very real possibility of deflation which bonds have been screaming about all year. The Fall Epiphany has only just begun, as the Russell 2000 craters, global markets falter (particularly in Europe), and volatility emerges like the phoenix from the ashes of complacency. The roadmap that people followed in the outlier period of Quantitative Easing 3 will not help going forward. You can not navigate storms as if seas are calm.

The IMF continues to cut global growth, and Fed officials over the weekend, surprise surprise, are now arguing that a rate hike may be delayed because of a strong dollar. Why apparently no one saw this change in tone coming is beyond me given the deflationary pressure a stronger currency has on a country. Nevermind that, however, given that rising rates for the Fed means nothing in the context of rising rates in the Junk Debt domain. On CNBC Friday I commented about the current state of markets, noting that there was the very real potential at some point for a Flash Crash repeat in equities if Junk Debt collapses. People forget that an hour before the Dow dropped 1000 points on May 6, 2010, Junk Debt had its own 1987-style crash. The real source of risk for equities remains potential panic selling to come in Junk Debt, punishing the bubble theme of searching for yield without regard for risk.

This is the kind of environment our ATAC strategies were built for. I was in Philadelphia earlier in the week presenting to the CFA Chapter there our award winning papers on predicting corrections and volatility using the signaling power of Utilities and Treasuries (http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=2224980). Someone during the Q&A noted that our research wasn’t really about taking risk. I said that was absolutely correct – everything we do is actually about when to LOWER risk pre, not post. Most people tend to hit the brakes after the crash, and not slow down entering the storm. The prolonged period of equity gains and tight correlations is ending, and may do so spectacularly given just how many weak hands there are. Recent sentiment data shows that suddenly, fear is dominating. One might argue that is a contrarian signal, and as such now stocks have to rise. However, the anchor is wrong. This volatility is absolutely nothing compared to what may be to come in order to resync equity sentiment to sentiment in nearly every other area of the investable landscape.

For our quantitatively driven, unemotional, academically sound and tested ATAC models, that means we continue to be exposed in the near-term to Treasuries which tend to benefit from equity gyrations in our inflation rotation strategies. For our equity sector beta rotation strategies, that means we continue to position all-in on Utilities, Consumer Staples, and Healthcare which were among the best performing sectors last week.

Stocks are not oversold. They remain massively overbought relative to growth and inflation expectations. That is not opinion – that is based on looking beyond the small sample to the large data set of time and market cycles. The time to Fight the Fed has come. Its time to remind traders and investors that mathematically, wealth isn’t generated by managing return, but rather by managing risk. If indeed this is only the beginning, watch our strategies, and seriously consider allocating to them. You may be shocked at how fast and aggressively we outperform our benchmarks because the very nature of our strategies is to go to the extremes of the defensive spectrum when conditions favor it most.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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The End of QE and the Return of Risk Management

Risk management has become a four letter word. It has been more than two years since the S&P 500 Index has suffered a correction greater than 10% in what has become the longest uptrend in the history of markets.

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Naturally, no one cares about risk management today as stocks have behaved like a risk-free asset class. If you have managed risk or maintained a diversified portfolio during this period you have looked like a court jester as every minor dip has been followed with a v-shaped rally back to new highs. But as I have been arguing in recent weeks, this benign environment is coming to an here and there is likely to be a renewed appreciation for risk management in the coming weeks and months.

The underlying force driving the unrelenting advance over the past few years has been the faith and comfort that investors have derived from the easiest monetary policy in history. Since December 2008, we have seen a zero-percent Fed Funds Rate, three rounds of quantitative easing, and an expansion in the Fed’s balance sheet to over $4.4 trillion.

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But as you’ll notice in the chart above, Fed balance sheet growth is starting to flat line here as we approach the end of QE3 this month. With this in mind, investors may want to look back at how the market environment changed following the end prior rounds of QE.

The first quantitative easing program (QE1) ended in March 2010. In the months that followed, the S&P 500 Index would experience a peak to trough decline of 17%. A second quantitative easing program (QE2) was commenced later that year, and continued until June 2011. In the following months, the S&P 500 Index would experience a peak to trough decline of 21%.

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We also saw a large spike in volatility following the end of QE1 and QE2 with the VIX Index moving above 40 during both occasions.

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Within the S&P 500 Index, there was a clear divergence between defensive and cyclical sectors during the post-QE declines. In the three months that followed the end of QE1 in 2010, the defensive sectors (Utilities, Consumer Staples, and Health Care) performed at the top of the sector rankings while the more cyclical sectors underperformed.

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We observed a similar pattern in the three months that followed the end of QE 2 in 2011, with Defensive sector outperformance. The lowest beta sector in the S&P 500, Utilities, actually posted positive performance during this period.

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We also saw significant outperformance of defensive long bonds (30-year Treasuries) over stocks following the end of prior rounds of QE.

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There are now only three weeks left until the end of QE. Most market participants are still saying it will be different this time. They don’t believe that stocks can go down because they haven’t seen it happen in a long time.

As I have been arguing all year, though, real money investors have already been repositioning out of cyclical areas of the market and into defensive areas ahead of the end of QE (see Fed Prisoner’s Dilemma). The most defensive areas of the market including Utilities and long duration Treasuries are widely outperforming stocks in 2014. Given this backdrop, defensive sector rotation and risk management is likely to become a more important factors for investors going forward. The environment that has been in place since late 2012 is coming to an end and with it will go the notion that U.S. equities are a risk-free asset class.

At Pension Partners, our mutual fund and separate account strategies are currently in defensive mode, with positions in defensive sectors in our equity sector rotation strategy and Treasuries in our absolute return strategy.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

 

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