All posts by Charlie Bilello

The End of QE and the Return of Risk Management

Risk management has become a four letter word. It has been more than two years since the S&P 500 Index has suffered a correction greater than 10% in what has become the longest uptrend in the history of markets.

End1

Naturally, no one cares about risk management today as stocks have behaved like a risk-free asset class. If you have managed risk or maintained a diversified portfolio during this period you have looked like a court jester as every minor dip has been followed with a v-shaped rally back to new highs. But as I have been arguing in recent weeks, this benign environment is coming to an here and there is likely to be a renewed appreciation for risk management in the coming weeks and months.

The underlying force driving the unrelenting advance over the past few years has been the faith and comfort that investors have derived from the easiest monetary policy in history. Since December 2008, we have seen a zero-percent Fed Funds Rate, three rounds of quantitative easing, and an expansion in the Fed’s balance sheet to over $4.4 trillion.

End2

But as you’ll notice in the chart above, Fed balance sheet growth is starting to flat line here as we approach the end of QE3 this month. With this in mind, investors may want to look back at how the market environment changed following the end prior rounds of QE.

The first quantitative easing program (QE1) ended in March 2010. In the months that followed, the S&P 500 Index would experience a peak to trough decline of 17%. A second quantitative easing program (QE2) was commenced later that year, and continued until June 2011. In the following months, the S&P 500 Index would experience a peak to trough decline of 21%.

End3

We also saw a large spike in volatility following the end of QE1 and QE2 with the VIX Index moving above 40 during both occasions.

End4

Within the S&P 500 Index, there was a clear divergence between defensive and cyclical sectors during the post-QE declines. In the three months that followed the end of QE1 in 2010, the defensive sectors (Utilities, Consumer Staples, and Health Care) performed at the top of the sector rankings while the more cyclical sectors underperformed.

End5

We observed a similar pattern in the three months that followed the end of QE 2 in 2011, with Defensive sector outperformance. The lowest beta sector in the S&P 500, Utilities, actually posted positive performance during this period.

End6

We also saw significant outperformance of defensive long bonds (30-year Treasuries) over stocks following the end of prior rounds of QE.

End7

There are now only three weeks left until the end of QE. Most market participants are still saying it will be different this time. They don’t believe that stocks can go down because they haven’t seen it happen in a long time.

As I have been arguing all year, though, real money investors have already been repositioning out of cyclical areas of the market and into defensive areas ahead of the end of QE (see Fed Prisoner’s Dilemma). The most defensive areas of the market including Utilities and long duration Treasuries are widely outperforming stocks in 2014. Given this backdrop, defensive sector rotation and risk management is likely to become a more important factors for investors going forward. The environment that has been in place since late 2012 is coming to an end and with it will go the notion that U.S. equities are a risk-free asset class.

At Pension Partners, our mutual fund and separate account strategies are currently in defensive mode, with positions in defensive sectors in our equity sector rotation strategy and Treasuries in our absolute return strategy.

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.

 

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

  • No Related Posts

Anatomy of a Market Top

“If it keeps on rainin’, levee’s goin’ to break.” – Led Zeppelin

Crashes get all the headlines, but the reality is that a breakdown in markets is more often a process than an event. It takes time to break the back of a strong uptrends as there are many buyers on the sidelines eager to “buy the dip.” This is why you tend to see a period of back and forth, a rotation from strong hands to weak hands, before the sharper declines ensue.

If we look at the average stock in 2014 as reflected by the Russell 2000 Index, this is precisely what we have been witnessing for the entire year.

Top1

Where have we seen this before?

2000…

Top2

2007…

Top3

The First 7 months of 2011…

Top4

But It’s Different This Time

The perception today is that it’s different this time. This belief stems from the view that the Fed has repealed the business cycle and eradicated market corrections through nearly six year of 0% interest rates and multiple rounds of quantitative easing. The validation for this narrative comes in the form of price action and the longest uptrend in the history of markets. At 471 trading days above the 200-day moving average in the S&P 500, most cannot remember a time when equities did anything but go up.

Streak 10-8

Perhaps the Fed true believers are right, you say, and the uptrend will last forever. Anything is possible in markets but the more likely scenario is that it’s finally coming to an end here.  The sustained weakness in small caps, high yield credit, and cyclical sectors is becoming too much for large caps to ignore (see here for comparison to 2007).

Small caps, mid-caps, Emerging Markets, and European equity markets have all tested their 200-day in recent days/weeks. All that remains is large caps; it is the last shoe to drop. I have been arguing for much of the year that investors have been rotating into U.S. large caps and defensive areas, hiding in anticipation of the end of QE in October (see “Fed Prisoner’s Dilemma”).

Well, October is here and investors may soon come to understand that U.S. large caps are not a risk-free asset class, in spite of what Fed has done over the past six years.

The chart below of the Russell 2000 is likely to become very important in the coming months. It illustrates the back and forth action that is reminiscent of 2007.

I’ve heard a number of perma bulls call this a “beautiful consolidation,” just a pause before the next sharp move upward. Perhaps, but if they are wrong and the levee of support (YTD lows in February and May) is broken, there could be significant downside ahead.

Top6

Will it break or will it hold? On this question I’ll defer to the wisdom of Page and Plant: “If it keeps on rainin’ [negative intermarket relationships persist], levee’s goin’ to break.”

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.

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

  • No Related Posts

Back to the Future Part III: The Hunt For Red October

Hunt1

I know what you’re thinking. Is he really combining two different early 90’s movies into an article title? That’s pushing the limits of clickbait. Fair enough, but hear me out. It will hopefully make some sense by the end of this piece.

In late May, I took you “Back in Time,” writing about the many similarities between 2007 and 2014. In July, I wrote of the continuing parallels in “Back to the Future Part II“. In that piece I reminded investors that in 2007 stocks finished higher on the year and did not ultimately peak until October. However, I cautioned: “whether investors knew it at the time or not, they were incurring a very high risk for only a few percent reward that year.”

It’s hard to believe but October is here. Do the parallels to 2007 still exist? Let’s go back in time to October 2007 and find out.

Hunt2

It’s October 2007. The S&P 500 is up over 9% on the year and investors are broadly optimistic as the Bull Market is five years old and headlines featuring “new all-time highs” are seemingly everywhere.

Hunt3

Meanwhile, the intermarket action is telling a different story, with the defensive Utilities sector outperforming while Consumer Discretionary, Banks and Housing names are lagging.

Hunt4

We’re also seeing a noticeable divergence between the S&P 500 (large caps) and Russell 2000 (small caps) with the latter underperforming. In the third quarter, the S&P 500 would finish higher, masking broader weakness as the Russell 2000 declined.

Hunt5

The credit markets are also sending a different signal than the S&P 500 with high yield credit spreads wider on the year, well above their June lows.

Hunt6

Collectively this is highly defensive behavior and while the broad market is largely ignoring it, the risk/reward is clearly changing.

Hunt7

Back to October 2014 and we are seeing a very similar backdrop. The bull market is over five years old, it has been over two years since there has been a sizable pullback, and we seem to read about “new all-time highs” in the S&P 500 every day.

Hunt8

Given this backdrop, like October 2007, investor sentiment is extremely optimistic.

Hunt9

However, while the large cap indices remain strong, the intermarket action is considerably weaker. Just as was the case in October 2007, the defensive Utilities are outperforming while the cyclical Consumer Discretionary, Banks, and Homebuilders are all lagging.

Hunt10

As I have been writing about for much of the year (click here for most recent piece), we are also seeing a massive divergence between small caps and large caps. Last quarter, we saw small caps decline while large caps advanced. Where have we seen this before? That’s right, we were just there. This was the first time this occurred since the third quarter of 2007.

Hunt11

In the credit markets we are starting to see signs of weakness as well. Like 2007, spreads bottomed in June and are wider on the year here in early October.

Hunt12

The Hunt For Red October

Submarine - 10-7-14

As was the case in October 2007, on the surface all is calm today. But unfortunately, this is not the only similarity between the two periods. Lurking underneath the surface, like the submarine Red October, are potentially dangerous divergences in cyclical sector weakness, small cap weakness, and junk bond weakness.

Collectively, these signals are sending a warning sign to markets: after five years of gains, the risk/reward is changing, and not for the better.

It remains to be seen how the rest of the year plays out and whether this leads to a run-of-the-mill correction or something more. Most seem to be assuming that it will lead to nothing as that has been the case thus far in 2014 (see “The Bear Who Cried Wolf”). For those looking for an exact replica of 2007 for this analysis to be valid, you will surely be disappointed. It will most certainly be different today than 2007 as it is never exactly the same.

What is the same, though, is the fact that underlying conditions have weakened, and as long as they persist, the odds favor a more defensive posture. I realize that is not as alluring as someone picking an exact time and date top, but it is the best we can do in markets. Defense or offense – what are you more focused on today?

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.

facebooktwittergoogle_pluslinkedinmail  rssyoutube

Related Posts:

  • No Related Posts