ATAC Week in Review: The Bull’s Self-Delusion

“Stocks have reached a permanently high plateau.” – Irving Fisher, just before the 1929 Crash

Equities and Treasuries closed August having one of their best months of 2014 respectively, as bonds continue to price in global deflation at the same time equities completely ignore that possibility.  Global inflation has fallen to 56 month lows according to GaveKal research, which indicates that bonds have future growth and inflation expectations right.  To say that Treasuries are in a bubble or are yielding nothing lacks of a fundamental understanding of what real returns after inflation are.  If a bond yields 0.1% and inflation is -10%, that is a phenomenal rate of return.  Whoever thinks that low bond yields and falling rates are bullish have fallen prey to a narrative which Japan has disproven.

Put simply, bonds are correctly pricing in deflationary risks.  Stocks are not.  That is not open to debate.  That is fact.

Yet, of course the narrative of stock market movement always follows price, as the crowd deludes itself into trying to justify why equities should continue at this pace.  People forget that interest rates are the heart, soul, and life of the free enterprise system, and that falling rates are reflective of the demand for money.  That demand for money drives everything, and is the core fundamental difference between socialism and capitalism.  To completely forget the fact that bonds tend to be more right than stocks about the future, and to ignore the enormous disconnect between the two, is simply lunacy and completely disregards cause and effect.  Economic data continues to be marginally positive, but what happens when data actually begins to miss expectations?  What will bond yields do when data is actually worsening when they have been falling into better data points?

Being on the road, I am glad to see that other colleagues and professionals in my field are first and foremost focused on process and academic research.  Far too many investing in markets completely ignore large samples, award winning papers, historical results over multiple years of money management, and context.  There is an old adage that when performance is strong, you sell performance.  When performance is weak, you sell process.  No – process drives everything, long sample periods are all that matter, and context appreciation is the only way to understand results.  Those that continue to be mesmerized by buy and hold investing ignore the context of the boom in equities given factual deflationary pressure everywhere, and how fast declines can happen when you least expect it.

Stocks are not meant to be a deflation hedge.  Once again, this is not open to debate, and is fact.  Japan’s Nikkei average has had multiple 20+% moves before ultimately collapsing and repeating the cycle.  What matter is if process leads to repeatable results.  What matters is if wealth is created through big gains, or the avoidance of big losses.  What matters is a strategy, rather than an opinion.  This is not about calling for a top in stocks.  This is about calling for a top in strategy.  Buy and hold investors have been deluding themselves into thinking there is no risk, and that stocks have reached a permanently high plateau.  Yet, bonds are screaming and no one seems to care.  When the crowd does, it will likely be too late to manage risk.

We all live in but a small sample of time.  Many investors simply look at results, and say that a cherry picked sample in time – which disregards award winning research, knowledge, and time tested strategies -  means stocks have nowhere to go but up.  This is as delusional as thinking that doing a Google search on your physical symptoms gives you more knowledge and experience than a doctor who spends his or her whole life mastering the field of medicine.  If bonds are right, the self-diagnosis of chasing high beta cyclical stocks is going to have some nasty side effects.  For our alternative, absolute return uncorrelated inflation rotation strategies, when Treasuries diverge from equities, the resulting spread can be substantial.  For our equity sector beta rotation strategies, risk management means taking a long-only sector position in those sectors which tend to be less sensitive to equity volatility and economic weakness.

And that, Nouveaux Bulls and Gray Haired Bears, is the only bottom line that matters.

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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Waiting For An Inverted Yield Curve, Waiting For Godot

Two sell-side strategists are waiting on a country road by a tree. What are they waiting for? Yield curve inversion.

Why are they waiting for it? They explain: “it has a flawless track record, predicting every U.S. recession in the past fifty years.” As recessions tend to be bad for the stock market, and the yield curve is not currently close to being inverted, the sell-side strategists are extraordinarily bullish. “We have many more years to run,” they agree, “both in the economy and the stock market.”

Let’s examine this thesis.

Predictive Power

An inverted yield curve has indeed been an early warning sign of an oncoming recession. The past nine recessions in the U.S. were all preceded by yield curve inversion, with an average lead time of 14 months.


Note: In this analysis I am using the difference between the 10-year yield and 1-year yield as the measurement of the yield curve. Other commonly used short-term rates are the 3-month and the 2-year.

As we know, though, the stock market also tends be a leading indicator of oncoming recessions. Thus, for yield curve inversion to be a market signal it is important that the inverted yield curve not only lead the economic turn but also the turn in the stock market.

As the table below indicates, this is more often than not the case. In the past nine recessions, yield curve inversion has preceded the stock market peak six times with an average lead time of 7 months. Most recently, we saw the yield curve invert in January 2006, well in advance of the stock market peak in October 2007.


Yield Curve Today

As of the end of July, the spread between the 10-year Treasury yield (2.54%) and 1-year Treasury yield (0.11%) was 2.43%. At 2.43%, the yield curve is far from inversion, supporting the argument of the sell-side strategist.


The Fed

The problem with this simple interpretation, though, is that current Federal Reserve policy is unlike any of the prior recoveries in which the yield curve eventually inverted. The difference is glaring when looking at the chart below. We are now over five years into the recovery that began in June 2009 and the Federal Funds Rate remains at 0%-0.25%, the same level it stood at in December 2008. This is by far the longest period of time the Fed has left the Funds Rate at a trough level following a rate-cutting cycle and new economic expansion.


Manipulating the Curve

By holding short-term interest rates near 0%, the Fed has effectively made it impossible for the yield curve to invert. With the 1-year Treasury yield at 0.11%, for the curve to invert the 10-year Treasury yield would have to cross below this level, an unlikely event. The table below illustrates that the average Effective Federal Funds Rate at the time of prior yield curve inversions was 6.16%, and the lowest Funds Rate at inversion was 2.94% back in 1956. At a 0.09% Effective Funds Rate, we are far from such levels today.


Still, most will argue that if the Fed has the ability to prevent a yield curve inversion then they have the ability to prevent recessions and bear markets. Fair enough assumption, but…

Then There’s Japan

The Bank of Japan has held their discount rate near 0% for nearly twenty years, since 1995.


While this has been successful in preventing an inverted yield curve, it has been less successful in preventing recessions as can be seen in the chart below. Japan has experienced recessions time and time again since 1995 in spite of 0% rate policy.


But “We’re Not Japan”

The counter to the Japan example is the simple statement that “we’re not Japan.” This is certainly true as there are many differences in our economies and we are not fighting outright deflation as our demographic issues are not nearly as troubling as in Japan.

Still, while we may not be exactly like Japan, there are a number of similarities. Most important among these is that our central bank seems to believe that we are very much like Japan as they are following the same monetary policy. Both in terms of endless balance sheet expansion through quantitative easing and extended zero-interest rate policy, we look very much like Japan.

We also look like Japan in that growth during this recovery has been the weakest in history, hovering between 1-2% per year.


Another similarity is the stagnation in real wages. This has been the weakest expansion in terms of real wage growth in history.


Still, you remain unconvinced. Japan may have had multiple recessions/bear markets without a yield curve inversion, but we’re different. Perhaps, but…

You Can Have a Bear Market Without An Inverted Yield Curve

The stock market is not the economy and vice versa. While an inverted yield curve has tended to precede stock market weakness, you don’t need an inverted yield curve to have stock market weakness. There have been five bear markets without any yield curve inversion or recession, most recently in 2011.

Bear Mkts WO Inversion - 8-27

You can also have an inverted yield curve without a recession, as we saw in December 1965 through February 1967. There was, however, a bear market during that time, from February 1966 through October 1966 when the S&P 500 declined 23.7%.

Waiting for Godot

In the famous absurdist play “Waiting for Godot,” the two main characters (Vladimir and Estragon) wait endlessly for a man named, you guesses it, “Godot.” Needless to say, Godot never arrives.

In today’s markets, we have a similar parallel where most strategists and economists are waiting for yield curve inversion before they take a more cautious or defensive stance. However, as long as zero-interest rate policy continues, yield curve inversion is unlikely to arrive. They are likely to keep waiting.

Does that mean that U.S. equity markets are without risk?

Certainly not, though this seems to be the consensus these days. First, we have the example of Japan that has not changed its interest rate policies in twenty years but has had multiple recessions and bear markets during that time. Second, we know that even in the U.S. we have had multiple bear markets (as recently as 2011) without yield curve inversion. Thus, risk still remains but a yield curve inversion is simply unlikely to signal it this time around.

“Canceling Signals”

“This is a big, big gamble to be manipulating the most important price in free markets, interest rates. These purchases are canceling market signals. The bond market and the stock market have provided wonderful signals for many years as to potential problems. And when you cancel those signals, you could run into a problem. I don’t know when it’s going to end, but my guess is it’s going to end very badly.” – Stanley Druckenmiller

You simply cannot analyze today’s markets with an indicator like yield curve inversion because the Fed is doing something they never did before: holding rates at 0% for over five and a half years. Economic theories that explain how yields vary with maturity have been rendered irrelevant. The liquidity premium theory? Throw it out. The market segmentation theory? Forget it. The preferred habitat theory? Useless. The Pure expectations hypothesis? Unusable.

The reason why an inverted yield curve is predictive of economic weakness is that long-term bond investors will settle for lower yields if they start to believe the economy will slow or decline in the future. They accept lower yields in because they believe short-term rates will fall as the real demand for credit weakens during a recession and the Fed starts cutting rates. Locking in a lower yield on a 10-year bond than what you could earn on 1-year bond makes economic sense if you believe that when the 1-year bond matures the rate you can reinvest at will be much lower.

In today’s market environment, you already have short-term rates at 0%, so market participants cannot assume that the Fed will lower rates if economic weakness ensues. The most that they can assume is that the Fed will simply keep rates at 0% for a longer period of time. This would in turn drive demand for longer-term debt, leading to a flattening, but not outright inversion, of the yield curve.

This is precisely what has been occurring all year in 2014, with the yield curve flattening. It won’t lead to inversion because investors are unlikely to accept 0% on a 10-year bond, no matter how bad they expect future economic growth to be. We have seen this in Japan which has experienced multiple recessions without the 10-year yield moving below the 1-year yield.

Bottom Line

The implications for investors and markets today are as follows.

1) As long as the Fed is operating under 0% policy, yield curve inversion is not a valid risk management signal as inversion is essentially impossible. What would the yield curve look like today if the Fed had normalized policy years ago as they did following every other recession in the past fifty years? Would the yield curve already be inverting here? We simply don’t know.

2) It remains to be seen what occurs first, a change in Fed policy or economic weakness. Most are assuming the former, where the slow growth expansion continues and the Fed starts raising rates next July. At that point, market participants are expecting the Fed to slowly raise rates and the yield curve inversion signal to eventually come back into play years later, signaling future economic weakness. While this is certainly one scenario, it is not the only scenario. If the latter (economic weakness) occurs first, we could be looking at a Japan scenario of a recession/bear market during an extended period of low interest rates. Most investors consider this scenario unlikely but it is something we should at least be considering.

3) In any case, the idea that equity markets are currently risk free because the yield curve is not inverted is not supported by history, most recently in 2011.

4) As long as ZIRP remains in place, investors would be wise to look beyond yield curve inversion for guides to risk management and asset allocation. At Pension Partners, we authored two award-winning papers in 2014 that focus on the unique behavior of the utilities sector and Treasuries as indicators of increased volatility and risk in the market. These signals are used in our mutual funds and separate accounts where we employ a quantitative investment and risk management process. Importantly, these signals are not reliant on yield curve inversion.

5) Regardless of the shape of the yield curve, for the reasons outlined in “Has The Fed Doomed Buy And Hold,” I believe the environment going forward is likely to favor more tactical strategies over buy and hold. I also believe that risk management is likely to be a more important factor as we approach the end of QE3 in October (see “The Fed Prisoner’s Dilemma”).


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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ATAC Week in Review: What Can Break Treasuries

“We are near, very near, to an end to the eurozone crisis… The worst – in the sense of the fear of the eurozone breaking up – is over. But the best isn’t there yet.” – Francois Hollande

Stocks rallied as yields nudged higher following the prior week’s break in market internals as tensions “eased” in the Ukraine and markets continued to disregard any kind of warning signs that things could get more challenging. Investors and traders turned their focus on the Fed yet again, with the media reciting Yellen’s Jackson Hole comments. I suspect the word “slack” is going to be this year’s taper in terms of frequency of word use, as the Fed debates when to raise rates with wage reflation still nowhere to be found.

What happens in the U.S. may end up being a side show relative to Europe now. More and more traders and investors are convinced that Quantitative Easing in the Eurozone is inevitable, and that we may see bond buying by the European Central Bank by December. I do not disagree, largely because Germany’s economy is now contracting and there is less reason for pushback on large scale monetary action. Inflation expectations have been cratering in Europe, and it remains to be seen if the ECB can indeed reverse that trend.

I have noted before that I find the notion that QE can reverse deflationary pressure curious, given that QE failed to achieve its objectives in Japan and the US. However, if Draghi initiates QE and inflation expectations rise, then European yields likely rise and that could finally break the Treasury uptrend and high correlation over the last several months between stocks and bonds. This is much needed for alternative strategies like our primary inflation rotation approach. In a world where everything is correlated to the upside, the only way to be uncorrelated is to not participate to the same extent. Every time a central bank has initiated QE, yields rose. If this happens in Europe, it would take US Treasuries down and finally create a marginal rising rate environment so many have been wrong on for so long.

As correlations normalize and the Fed gets out of QE, we fully expect more normalized intermarket relationships to take hold, which from the standpoint of tactical trading across asset classes and sectors is a very positive thing for our strategies. Every day we get closer to that type of environment which can meaningfully alter the signaling power of the inputs that go into our primary risk trigger which causes us to rotate into or out of various investable instruments. I continue to be very excited for that environment to reassert itself as it did in 2012 which was a particularly strong year for our ATAC approach.

The coming week will be another one filled with travel for me. For those in Kansas City, I encourage you to sign up to my CFA presentation on predicting stock market volatility and corrections ( From the standpoint of asset class choice and sector movement, small-caps may begin to stage a period of near-term outperformance, and energy (from a beta rotation standpoint) could finally begin to strengthen after meaningful weakness.

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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