The Illusion of Stability

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U.S. equities continue to trade like a risk-free money market. Over the past seven months, the range (from high to low) in the Dow Jones Industrial Average has been among the smallest in history.

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This behavior has been comforting to most investors as they tend to equate low volatility with low risk. Additionally, every time there is minor spike in volatility, it soon collapses. We saw this in extreme fashion this month after Greece agreed to yet another bailout. The news was followed by the largest 5-day decline in the history of the VIX Index.

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Behind this illusion of stability, though, are a number of signs pointing to increasing fragility…

1) S&P 500 earnings are likely to decline (year-over-year) for the third consecutive quarter.

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2) S&P 500 sales are likely to decline (year-over-year) for the second consecutive quarter.

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3) Credit risk is rising with U.S. Investment Grade spreads approaching multi-year wides.

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4) High Yield credit is also weakening, with spreads widening and negative total returns over the past year.

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5) Breadth within the equity market is deteriorating. While the S&P 500 is near all-time highs, only 42% of stocks in the NYSE are above their 200-day moving average.

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6) The yield curve is starting to flatten again, with long duration bonds outperforming shorter duration issues (for why this matters, see our research on Treasury Bonds).

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7) Breakeven inflation rates are falling again as commodities collapse and expectations for global growth are declining.

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8) Industrials, a key cyclical sector that typically correlates with the broad market, is showing extreme relative weakness.

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9) Emerging Market currencies are moving lower again, with many currencies like the Brazilian Real at multi-year lows. This is major issue for Emerging Market companies that issued a record-high $276 billion of dollar-denominated bonds in 2014.

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10) The first rate hike in 9 years is getting closer. Fed Funds Futures are currently predicting a December hike, only five months away. This is the closest market expectations have been to a rate hike since 2009.

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“But No One Cares”

Collectively, these factors point to an equity market that is increasingly fragile and in the past one that was about to become much more volatile. The response from market participants today: “no one cares.” Volatility is low, stocks are still acting like a 6-month CD, and monetary policy is easy.

All true, but investing is about the future, not the past. No one knows when the Minsky moment of this cycle will occur, but a necessary precursor is low volatility and the illusion of stability. Add fragility to the equation and you have a powder keg just waiting to explode.

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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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Stocks Fall On…

Stocks are down today and you want to know why. We all do; the need to explain things is an innate characteristic of humans. A random walk down Wall Street doesn’t suffice. We want something more tangible, something in the news, something non-random.

There will be no shortage of explanations for today’s decline, ranging from a potential Greek default to China’s stock market collapse to a “technical glitch” that halted trading on the New York Stock Exchange.

For passive consumers of news, any of these rationales will serve their purpose (explaining the why) and are more or less harmless.

For investors, though, they can be quite harmful indeed. Why?

Because we are emotional beings and our impulsive response to bad news is to panic and sell after the fact. This would be bad enough on its own, but we also respond to good news and higher prices by panic buying (fear of missing out).

The S&P 500 is only down 4% from its recent all-time high (though it feels much worse because the S&P has been behaving like a risk-free CD). That pales in comparison to what we saw from 2000-02 (51% decline) and 2007-09 (57% decline). It also doesn’t yet measure up to the 18 previous corrections greater than 5% since the March 2009 low.

All of these corrections had fear-inducing explanations associated with them that seemed like the end of the world at the time. All were soon followed by new stock market highs.

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That may or may not be the case this time around. It could be another run-of-the-mill correction or it could be the start of something bigger. We’ll only know in hindsight. Regardless of what happens next, reactionary buying and selling is not likely to be a successful investment strategy. If you can’t handle a 4% decline in stocks, you own too much equities. Lower the beta in your portfolio to your risk tolerance, to the point where you can sleep at night.

This is not to say that being more tactical, especially at this point in the cycle, is unwarranted. As I wrote on the six year anniversary of the bull market in March of this year, the next six years is not likely to mirror the last. This should favor more active strategies, particularly ones that focus on risk management.

It’s just that the execution of such a strategy should be systematic and unemotional. In plain English: you need a process to stand a chance. If you sell today, when do you buy back in and what is the catalyst for doing so? If you can’t answer that question with a repeatable process, stick to your investment plan. If you still feel the need to be more tactical, outsource it.

The news should play no role in how you manage your money because the news tells you what has happened, whereas investing is about anticipating what will happen. The time to think about and position for rising risk in markets is ex ante, not ex post. By the time the October 2002’s and March 2009’s come around, it’s too late.

Now back to your regularly scheduled program

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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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When Fear of Bonds Exceeds Fear of Stocks

Worried about your bonds? You’re not alone.

In speaking with our investors in recent weeks, the most universal theme by far was concern over their bond holdings. Historically low interest rates coupled with the prospect of the first Fed rate hike since 2006 (“rising rates”) were causing anxiety. And most importantly, the average bond fund was down in the first half of the year. There’s nothing more fear-inducing to investors than short-term losses.

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To be fair, some of these concerns are warranted. The elephant in the room is that lower bond yields are likely to lead to higher volatility and lower returns going forward. Investors who aren’t preparing for this are surely to be disappointed.

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But what about stocks? Given negative earnings growth in the past two quarters and extreme valuations, you would think there would be some level of concern there as well.

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But surprisingly, these same investors who were fretting about their bonds seemed extraordinarily complacent when it came to their stock holdings.

Why? Well, it’s been a long time since stocks have done anything but go up. The Russell 3000 has advanced 12 consecutive quarters, the second longest streak in history. As I wrote last week, U.S. stocks have been behaving like a 6-month CD.

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Does that mean investors are right to be more worried about their bonds? No. This is recency bias in its worst form. Even a cursory examination of the history reveals higher risk in equities…

Looking at the rolling 12-month volatility of stocks and bonds, we see that 99% of the time stocks have exhibited higher volatility than bonds. Only in the early 1980’s when interest rates on U.S. 10-year debt approached 16% did bonds briefly experience higher volatility than stocks.

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In looking at historical drawdowns, there’s no comparison. The S&P 500 has fallen in excess of 50% while the worst decline for the Barclays Aggregate was 12% (using monthly data). Bonds have also held up very well during periods of higher volatility in equities, traditionally acting as a defensive position (for more on this, see our recent research paper on Lumber and Gold).

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Now, I’m not suggesting that fear has any place in managing a portfolio. When it comes to investing, it is best to leave emotions out of it and stick to a systematic process whenever possible.

But if you’re going to worry about anything, given the historical record stocks would be a much more rationale choice. Equities are not the new “safe haven” despite their behavior in recent years. And from a contrarian standpoint, the fact that no one is worried about stocks today is probably telling us something. Invariably, just when the masses think nothing can go wrong in the investment world, a surprise is coming.

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 York

 

 

 

 

 

Charlie 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 three award-winning research papers on market anomalies 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 previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

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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