ATAC Week in Review: Inching Towards the Great Epiphany

“I always liked those moments of epiphany, when you have the next destination.” – Brad Pitt

Large-cap stocks made new all-time highs as emerging markets and small-caps failed to continue rolling momentum, at the same time the US Dollar surged.  Logic would dictate that a strong dollar would negatively impact multi-national large-cap companies relative to more domestic small-cap companies, but we remain in an environment defined by desynched relationships.  With currency wars in full effect between the Yen collapse and the Euro breakdown, magically headline averages seem to not care that earnings will likely be negatively impacted from currency movement.

I say this with sarcasm of course, as recent inflation data continues to prove that bonds have future growth and inflation expectations more right than stocks do.  Next week will prove to be important for the bond/stock relationship.  Yields rose as Mario Draghi announced a form of Quantitative Easing a few weeks ago, against that backdrop US inflation expectations collapsing as measured by the TIP/TENZ ratio.  This is happening at the same time Utilities have underperformed broad market averages, and long duration Treasuries have weakened relative to intermediate.  This is a continuation of non-normal behavior from last year.  Historically, Utilities tend to outperform the stock market and long duration Treasuries tend to outperform intermediate coincident with inflation breakeven movement.

If bond yields begin to fall next week, we are likely closer to a real “risk-off” period characterized by Treasuries meaningfully outperforming the stock market as they did from April-May 2012 (3000 basis points of outperformance in a period of 2 months), and Utilities, Consumer Staples, and Healthcare outperforming cyclical sectors.  In the case of the former for our mutual funds and separate accouns, that means our inflation rotation strategies would rotate out of equities and into Treasuries.  In the case of the latter, that means our beta rotation strategies would rotate out of cyclicals and into defensive sectors while maintaining equity exposure all-in.  Various testing and studies prove that the bulk of returns come primarily from avoiding big declines.  We have yet to experience one such period in equities more broadly.  That will change, and every day we get closer to that happening.

We are inching towards an epiphany that central banks are failing to generate growth and inflation in the context of the trillions of dollars unleashed in the hopes of achieving a more robust economic environment.  The environment is likely more fragile now than ever before since the financial crisis.  This is not hyperbole.  By definition, when complacency is as high as the pre-1987 crash, and when credit spreads are abnormally low, mean reversion becomes the invisible hand.  This does not have to mean a collapse is coming, but rather means that the abnormally high correlations between and across asset classes and sectors must break.  This is welcome news for tactical traders and those who have tested strategies across cycles beyond the small sample in time we all live in.

It is often said that large-cap equities are the last to go.  If that is true this time around, then October and the end of Quantitative Easing will result in a marked regime change beneath the market’s surface.

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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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:

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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:

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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.

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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%).

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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.

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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.

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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.

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

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

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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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