Lumber, Gold, and Volatility in Equities

What do Lumber and Gold have to do with volatility in equities? As it turns out, more than you might think. In our third research paper which recently received the 2015 Wagner Award from NAAIM, we uncover a powerful intermarket relationship between these two seemingly disparate commodities and the environment for equities.

Lumber’s sensitivity to housing, a key source of domestic economic growth in the U.S., makes it a unique commodity as it pertains to macro fundamentals and risk-seeking behavior.  On the opposite end of the spectrum is Gold, which is distinctive in that it historically exhibits safe-haven properties during periods of heightened volatility and stock market stress.

When you look at a ratio of Lumber to Gold, it is telling you something about the risk appetite of investors and the relative strength or weakness in economic conditions. When Lumber is leading Gold, volatility in equities tends to fall going forward. When Gold is leading Lumber, the opposite is true, and equity volatility tends to rise. The difference in historical volatility at nearly 6% per year is substantial, and as we outline in the paper which will be released in May, it allows an investors to position offensively or defensively in advance.

S&P - 4-20

What is the relationship showing today?

Lumber has been falling precipitously since the start of the year and underperforming Gold significantly over the past three months.

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Historically, this has preceded higher volatility and more difficult equity markets looking ahead. U.S. stocks were roughly flat in the first quarter and volatility remains near historic lows. But the relationship between Lumber and Gold is suggesting that conditions may be changing.

We are perhaps seeing this already in the economic data with the Bloomberg Economic Surprise Index currently at its lowest level since March 2009. Economic data continues come in weaker than expected, with misses last week in Retail Sales, Industrial Production, Housing Starts, and Building Permits.

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Thus far, investors have shrugged this off as a positive for stocks because it means the Federal Reserve may be more patient in raising interest rates. Indeed, after the latest string of weaker data, expectations for the first rate hike have been pushed all the way back to December.

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This has provided much comfort to investors who have become increasingly dependent on a continuation of 0% interest rates (which will hit 7 years in December).  Should this weakness persist, though, it will likely become harder to dismiss regardless of how dovish Fed comments may be. At the very least, if history is any guide, we should be prepared for higher volatility ahead.

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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Hunting for Growth

In the past few months, we learned that 4th quarter S&P 500 earnings declined 14%, their worst year-over-year decline of the expansion.

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With growth harder to come by, investors have been actively bidding up growth names wherever they can find them.

The Russell 1000 Growth Index (IWF) has outperformed the Russell 1000 Value Index (IWD) by over 5% thus far in 2015. We have seen similar outperformance in small cap growth (IWO) over small cap value (IWN).

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Looking at the difference in sector weighting between Russell 1000 value and growth indices, we can see that growth has benefited from the outperformance in Tech and Consumer Discretionary with an overweight in those sectors. Growth has also been aided from an underweight in Financials, Energy, and Utilities as those sectors have declined thus far in 2015.

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Sector performance in the first quarter has largely followed revenue growth, with Tech, Consumer Discretionary, and Health Care posting above-average revenue growth while Financials, Utilities, and Energy have shown below-average growth.

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With the release of 1st quarter earnings in a few weeks, it will be interesting to see if the outperformance of growth over value persists. If growth remains scarce, we could see a continued widening in this relationship. On the other hand, if growth comes in stronger than expected, particularly in the “value” overweight sectors such as Financials and Energy, we will likely see a convergence in performance.

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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The Currency Hedging Boom

The most dominant theme thus far in 2015 has been the global currency war, where central banks are fighting one another with new easing measures on a daily basis to debase their currencies. By my count, there have already been at least 28 easy money announcements in 2015.

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The direct by-product of this race to debase has been the unprecedented boom in currency hedging. With central banks intent on crashing their currencies to lift their equity markets, U.S. investors have caught on to the game.

Out of the top 10 ETF inflows in 2015, 4 are in currency hedged ETFs (HEDJ, DBEF, DXJ, and HEFA) for a combined total of over $18 billion.

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Why the stampede into hedged ETFs? Two main factors are at play.

First, you have the compelling narrative of massive QE in Japan and Europe, a crashing Yen and Euro, and the perception that there is no better way to take advantage of this than through hedged equities.

Second, performance chasing is in full effect as there have been few asset classes with better performance of late than hedged equities in Japan and Europe. Over the past five months hedged Japan (DXJ) and hedge Europe (HEDJ) are up over 32%.

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A good story coupled with strong momentum is simply too much for investors to resist, especially when a crashing Euro/Yen is viewed as a “can’t lose” trade. When faced with the choice of a hedged ETF vs. a non-hedged version, the performance disparity is so glaring it is no surprise investors are overwhelmingly choosing to hedge. Since the start of 2014, the hedged Europe ETF (HEDJ) is up over 25% while a comparable unhedged version (VGK) is down 1%. Why the enormous gap? The Euro is down over 21% during that time.

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Since Japan upped their QE program in 2011, the Yen has depreciated over 37% and the hedged Japan ETF (DXJ) has outperformed the unhedged version (EWJ) by 63%.

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All of this hedging has been highly profitable but it will only continue to be so as long as a) the currencies continue to depreciate and b) the market continues to perceive such depreciation as bullish for equities. The danger is that few investors buying in today are likely to realize that they are predominately playing a currency debasement game in buying these hedged equities. The rolling correlation between the Yen and the Nikkei, at -.94, illustrates just how dependent Japanese equities have become on a weaker Yen.

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Should there be an upward reversal in the Yen or the Euro, we would see the opposite effect and currency hedging would lower returns. The contrarian in me would say that given the massive inflows into these ETFs, perhaps we are closer to the end of the easy money debasement than investors believe. In the past year alone, we have seen assets in the hedged Europe ETF (HEDJ) increase from $1 billion to over $16 billion.

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At the same time, we are seeing record net short positions held by speculators in Euro futures.

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Perhaps these investors and futures traders will continue to be right and the Euro and Yen will fall from here to eternity. But on the off chance it isn’t as easy going forward, a modicum of caution may be warranted.

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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