ATAC Week in Review: The Risk-Off Setup Arrives

“And the day came when the risk to remain tight in a bud was more painful than the risk it took to blossom.” – Anais Nin

Last week several important things began happening from an intermarket standpoint, which make me even more excited for normalcy to come and for the potential of our own strategies to perform strongly. For the past several weeks, I’ve argued that any kind of Quantitative Easing coming from the European Central Bank would result in yields rising. History proves that bond buying from central banks seems to initially result in bond selling by investors, pressuring yields higher. That has indeed been happening, as European and US government yields have been rising, seemingly breaking the unrelenting downtrend that began at the start of the year. This of course assumes inflation expectations not only rise, but are sticky in terms of their uptrend.

Meanwhile, emerging markets and commodities have been sold off aggressively, primarily due to a strengthening dollar and some weaker economic data out of China. US large-caps sold off of on the week, with small-caps down less. One could argue that we are entering a falling stock and bond environment. I believe this is going to end up being wrong with hindsight. The best thing happening right now is Treasuries and defensive sectors going down at a faster pace than broader beta. This is necessary to have happen first before a real “risk-off” period favoring Treasuries and defensive sectors actually begins.

The problem all year has been that Treasuries and defensive sectors have led, but in a correlated way to cyclical equities. Treasuries historically tend to NOT be correlated to stocks, and as shown in the 3rd place award winning paper “An Intermarket Approach to Tactical Risk Rotation” I co-authored with Charlie Bilello, their leadership means stock volatility tends to increase. The problem is stock volatility not only has not increased throughout the year on that signal, but also the duration of ignoring that signal has thrown our own models off which use that and Utilities as part of the risk trigger for rotations.

I am relieved to see this breakdown now in defensive areas, and estimate that any kind of real risk-off pulse likely comes at the end of September to early October, just as the Federal Reserve ends QE. A sell-off in Treasuries and defensive sectors now gives them room to outperform on a real corrective juncture, and may finally give their signaling power a chance to revert to historical accuracy. For our alternative inflation rotation strategies, that means the rotation back to Treasuries can result in the same kind of meaningful outperformance as occurred during the Summer Crash of 2011, and mini-corrections of 2012. For our equity sector beta rotation strategy, that means the potential for meaningful long-only equity outperformance by positioning all-in on Utilities, Consumer Staples, and Healthcare.

The very nature of our strategies is to seek to achieve strong returns largely by being defensive at the right time, given that significant outperformance comes from mitigating the downside rather than aiming for upside. It is why in 2011 and 2012 we were able to achieve very strong returns for our separate account clients, and it is why in those years in dated writings, I myself became known for “calling” big macro up and down moves in various asset classes within weeks of those moves occurring. Both our mutual funds on the alternative and equity side, as well as our separate accounts, have the ability to take advantage of historical cause and effect. We have been living in a small sample in time which from a number of perspectives has been an extreme outlier. The fullness of time, however, rewards historical cause and effect.

Every outlier period comes to an end. I believe we are on the verge of that right now.

Sincerely,
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
Twitter: @pensionpartners
YouTube: www.youtube.com/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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Defense Wins Championships: The Defensive Sector Anomaly

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More risk equals more return. Less risk equals less return. This is one of the investment maxims dictated by the Capital Asset Pricing Model (CAPM). But is this always the case or are there market anomalies that show otherwise? Simply stated, is it possible to achieve a higher or equivalent level of return with lower risk?

In two research papers we wrote earlier this year, we argued that it is indeed possible. In the first paper, An Intermarket Approach to Beta Rotation, we illustrated a rotational strategy between the more defensive Utilities sector and the more offensive broad stock market that achieved higher returns with lower volatility. In the second paper, An Intermarket Approach to Tactical Risk Rotation, we illustrated a rotational strategy between the more defensive Treasuries and more offensive broad stock market that also illustrated higher returns with lower volatility.

In both papers, the key to superior risk-adjusted returns across multiple market cycles was defense, not offense. That is to say, minimizing downside volatility by being defensive ahead of periods of market stress was more important than being offensive ahead of more benign, risk-friendly periods.

In this piece, I want to extend this thought process to the ten sectors that make up the S&P 500. While there have been a number of studies showing the low-volatility anomaly as it pertains to stocks, I am focusing here specifically on the sector phenomenon.

Sector Classification

We can break the ten S&P sectors down into “cyclical” and “defensive” categories according to their annualized volatility as follows:

D2

This methodology generates seven cyclical sectors (Technology, Financials, Materials, Telecom, Energy, Consumer Discretionary, and Industrials) and three defensive sectors (Health Care, Utilities and Consumer Staples).

We find a similar cyclical/defensive demarcation if we break down the S&P sectors according to beta:

D3

Sector Performance

How have the sectors performed since data became available in October 1989?

Energy has been the best performer with an annualized total return of 12.1%, followed by Health Care (12.0%) and Consumer Staples (11.2%). This compares to an annualized return of 9.5% for the S&P 500. The worst performing sector has been Telecom with a gain of only 5.9% per year.

D4

The cumulative total return of the Energy sector (1606%) is almost double that of the S&P 500 (851%) and more than five times that of the Telecom sector (313%).

D5

Sector performance by calendar year shows that all 10 sectors finished positive in 11 out of 24 years, including the last two years (2012 and 2013). All 10 sectors finished negative in only two calendar years, 2002 and 2008.

D6

Sector performance rankings by year show Tech/Financials/Health Care leadership in the 1990’s, shifting to Materials leadership from 2000-2007, shifting to Consumer Discretionary leadership in the current bull market. It should be immediately clear from the chart below just how important sector rotation can be. While most tend to focus on stock picking, in reality it is your exposure to various sectors that is often the most decisive factor in determining your equity portfolio’s return.

D7

Cyclical versus Defensive Sector Portfolios: Defense Wins Championships

Needless to say, most in financial industry tend to focus on the more exciting cyclical sectors, particularly Technology. These stocks tell a better story with loftier growth prospects and more interesting products than their defensive counterparts. But do the actual returns of cyclical sectors measure up to the hype?

As it turns out, they do not. Since October 1989, an equal weighted portfolio of the three defensive sectors (Health Care, Consumer Staples, and Utilities) would have outperformed an equal weighted portfolio of the cyclical sectors (Technology, Financials, Materials, Telecom, Energy, Consumer Discretionary, and Industrials) by almost 1% per year, with a 10.9% annualized return for the defensive sectors versus a 10.0% for the cyclical sectors.

More importantly, this higher return would have been achieved with lower risk, as the defensive sector portfolio had an annualized volatility of 12.0% versus 16.1% for the cyclical sectors.

D8

Additionally, the Beta of the defensive portfolio, at .58, was nearly half that of the cyclical portfolio at 1.03.

D9

Maximum drawdown is also significantly lower for the defensive portfolio at -34.9% vs. -54.3% for cyclicals (note: using monthly data).

D10

Conclusions

The defensive sector anomaly stands in direct conflict with the CAPM. Not only does lower sector beta not equal lower return, but it has actually yielded higher return over the past twenty-five years.

The reason for its persistence is likely similar to that of the low-volatility stock anomaly, whereby several behavioral factors are at play. The most important among these factors is that investors tend to shun low volatility areas of the market for more exciting lottery type “story stocks” that have the potential (in their minds) for higher upside.  This, in combination with an overconfidence in their ability to assess the future, causes investors to overpay for higher volatility story stocks. Unfortunately, the reality oftentimes doesn’t match the initial story and lower returns on average are the result. While some of these stocks indeed achieve higher returns and meet expectations, most do not.

The same arguments can be applied to cyclical and defensive sectors, where investors are passing over the boring defensive sectors in favor of paying up for the more exciting cyclicals. Over time this has led to subpar performance, particularly on a risk-adjusted basis.

At Pension Partners, our equity sector rotation strategy benefits from the defensive sector anomaly but takes it one step further. Our strategy seeks to be fully in defensive sectors during  periods of higher volatility. These periods tend to exhibit contractionary behavior where defensive sectors can better preserve capital. However, we recognize that there is a time and place for cyclicals in a portfolio and our strategy will rotate fully into cyclical sectors during lower volatility periods. These periods tend to exhibit expansionary behavior where cyclicals are more likely to benefit and you are compensated for the additional risk you are incurring. We use a quantitative, objective process to determine when these rotations occur.

In summary, most in the investment management business focus solely on achieving the highest returns, and in doing so they naturally gravitate toward the higher volatility areas of the market. Our research has led us on a different path as we have found that it is the management of risk that is most critical in the long run. In striking a balance between offense and defense, offense may win games, but it is indeed defense that wins championships.

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.

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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Slackonomics 101

Slackonomics 101

It’s back to school time and there’s a new economics course being offered this fall at universities across the country: Slackonomics 101. The course will explore the revolutionary economic theory that is driving current Federal Reserve policy. The course outline and beginners guide to Slackonomics can be found below:

Chapter 1: Never Let a Crisis Go to Waste

Economic crises are to be viewed as an opportunity to expand the role of the Fed and justify its existence. When a crisis occurs, throw as much money at it as possible. Expand the Fed’s balance sheet, lower interest rates to 0%, just make sure to do something. Eventually the crisis will fade and you will be given credit for taking action and praised for its resolution.

Chapter 2: The Solution To the Crisis is the Cause of the Crisis

An extended period low interest rates by the Fed is one of the primary causes of the greatest housing bubble the world has ever known. The bubble bursts. What do you do? If your answer is anything other than moving interest rates down to 0% and keeping them there for the longest period in history, you don’t understand Fed policy. If there is a bubble and it begins to burst, simply start blowing it back up and you don’t stop blowing until another bubble forms. No one ever went broke underestimating the intelligence of the American people; they will be none the wiser and will even thank you for propping their asset prices back up, even if it is only temporary and leads to a massive misallocation of resources.

Chapter 3: If You Build It (a Bubble), They Will Spend

Once an economic expansion takes hold, do not be hasty in tightening monetary policy as was done in the past. Simply shift the rationale for easy money from “crisis mitigation” to a “wealth effect” built on the back of higher asset prices. After all, who wouldn’t get behind an idea like a wealth effect, where higher stock prices boost consumer wealth and help increase spending in a virtuous circle? Better yet, who would dare to stand against such an idea?

Chapter 4: When in Doubt, Do More, Never Less

Never let the facts get in the way of more easy money. If an economic expansion is the slowest in history and real wage growth is nonexistent, don’t view this as a failure of your policies. Use this as ammunition to shift the narrative once more. Instead of talking up a “wealth effect” which is becoming more difficult as the “wealth gap” has only widened under easy money policies, shift the focus to weakness in the labor market. Ignore naysayers who say that you already had the longest period of easy money in history and the labor market remains weak. They will never be able to prove the counterfactual so simply say that the labor market is still weak because we simply haven’t done enough yet. Works every time.

Chapter 5: Slack is the Word

Talk down any strength in the economy at every opportunity. Use the word “slack” as often as possible in describing the labor market.  This will maintain popular support for the longest period of low interest rates and exponential balance sheet growth in history (five and a half years and $4.4 trillion and counting). As a bonus, the trading algorithms love the word “slack” because it means extending the period of 0% interest rates. This in turn helps the wealth effect, etc., etc.

Chapter 6: Transient Noise

Dismiss any inflationary evidence as transitory or noisy. Focus not on the real life increases in costs for the average American household (housing, health care, education, taxes, food, etc.) but only your own narrow definitions of inflation (PCE, CPI, etc.). If there is no inflation under your definition, there is no inflation, period. Don’t entertain any evidence that shows otherwise. And if anyone suggests that driving up housing prices above levels that can be supported based on income is inflationary, just refer them to Chapter 3. The wealth effect outweighs any negative inflationary forces.

Chapter 7: Develop an Alibi

Don’t rest on your laurels, you know this is a short term game that will not end well. Protect your image and the Fed by making casual observations like there are “low levels of volatility” and there is “some evidence of reach for yield behavior.” The key is to make these observations with a straight face, never acknowledging the glaringly obvious relationship between Fed policy and risk-taking behavior. This is very important because despite your stated goal of propping up asset prices in the aforementioned “wealth effect” theory, you don’t want to be blamed when it all goes awry. Don’t worry, no one will call you out on this, just keep a straight face. For those killjoys complaining elevated valuations, throw them a bone by talking about “smaller firms in the social media and biotechnology industries.” Talking about a small subset of the market is ok, but don’t ever acknowledge the existence of a market wide bubble, even when it is staring you right in the face.

Chapter 8: Bubbles Will Be Bubbles

Whenever the topic of bubbles comes up, make sure to state convincingly that the Fed has no control over such things, can’t identify them, and even if they could it should not be their objective to stop or slow them down. Yes, we understand that this is a difficult concept to grasp as the Fed is allowed to inflate bubbles but this rule is not to be violated. The American people have grown to love a boom-bust economy and anyone who interferes with their precious bubbles will not be treated kindly.

Guest lectures here from Alan Greenspan and Ben Bernanke, discussing why you should never, ever acknowledge the existence of a bubble (they simply cannot be identified) and how to assume absolutely no responsibility for inflating the  bubble after it bursts.

Chapter 9: The Bigger the Word, the Better the Policy

Whenever possible, use big words that the financial media will endearingly refer to as “Fed speak.” It doesn’t matter if what you say makes no sense at all, just be sure to say it convincingly. “Macroprudential” is a wonderful word. Anything you say after it doesn’t matter. You had them all at macroprudential.

Chapter 10: But In the End…

Stop right there. Don’t worry about how it will all end; that is not your job. The buck stops with the next Fed chair, the next congress, not you. Your job is simply to keep inflating today and hope for the best. If Greenspan and Bernanke have been given a pass and even thanked for their heroic actions after bubbles have burst, you will too.

Sample Test Questions

1) Ben Bernanke has stated that he has what degree of confidence in the Fed’s ability to prevent inflation from getting out of control due to unprecedented easy money policies?

a) 0% b) 50% c) 75% d) 100%

2) Complete the pattern: QE 1, QE 2, Operation Twist, QE 3, ____.

a) No more QE b) Twist 2 c) QE 4 d) b or c

3) Janet Yellen used the word “slack” this many times during her Jackson Hole speech on August 22, 2014:

a) 0    b) 5    c) 10   d) 25

4) Interest rates will remain low for _______ after the asset purchase program (QE) ends.

a) a day b) a week  c) a month  d) a considerable or extended period of time

5) According to Ben Bernanke, the Fed is:

a) printing money b) not printing money c) a and b.

6) Don’t _____ the Fed!

a) pity  b) fool c) mock d) fight

7) _______ Ben.

a) Ranger b) Trucker c) Captain d) Helicopter

8) Back in Prehistoric times when the Fed actually increased interest rates after an expansion took hold, this was the old saying:

a) 3 sheets to the wind b) 3 hikes and you’re out c) good things come in threes d) 3 steps and stumble

9) Job gains have exceeded 200k in each of the last six payroll reports and jobless claims are at their lowest levels since 2006. The word that best describes the current labor market?

a) sluggish b)  slowing c) slackening d) all of the above

10) There are bubbles forming in:

a) collectibles c) real estate c) junk bonds/stocks d) everything e) nothing

Bonus Question: True or False: In 1979, a newly appointed Fed chairman increased the Fed Funds rate from 11% to 12% during a weekend in October. This became known as the Saturday Night Special. Two years later, this same Fed chairman would move the Fed Funds rate as high as 20% to fight inflation, knowing that it would likely send the economy into a recession.

a) True b) False

Answer Key:

1) d

2) d

3) d

4) d

5) c

6) c

7) d

8) d

9) d

10) e (remember, act like a Fed chairman, see Chapters 7 and 8 above)

Bonus: a

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.

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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