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An Intermarket Approach to Beta Rotation

We are honored to announce that the Market Technicians Association (MTA) has awarded us the 2014 Dow Award for our paper entitled “An Intermarket Approach to Beta Rotation.”

The full paper is now available to download on the Social Science Research Network (SSRN) (click here).

In the paper, we reveal a Beta Rotation Strategy (BRS) that uses the relative strength of Utilities to the market as an indicator to rotate into either the lower beta Utilities sector or the higher beta broad market.  Such a strategy would have achieved consistent outperformance on an absolute and risk-adjusted basis since 1926. Importantly, we also illustrate that when the strategy points to a rotation into Utilities, it can serve as a warning sign of increased volatility and extreme market movement in the short-term.

In the paper, we outline a modern-day implementation of the strategy using Exchange-Traded Funds (ETFs). The two ETFs that most closely approximate the index data from 1926 were the Utilities Select Sector SPDR (XLU) and the Vanguard Total Market VIPERs (VTI). We thought it would be informative to show how the ETF BRS would have performed in the first quarter of this year.

Through the end of the first quarter, the ETF BRS returned 6.85% vs. a return of 2.06% for the market (VTI). Similar to the results outlined in our paper, the key to this outperformance was the avoidance of risk.

Specifically, the ETF BRS rotated into Utilities (XLU) at the close on January 3rd, well in advance of the market’s peak on the 21st of January. The trigger for this rotation was the increase in relative strength in Utilities, which again, can be an early warning sign of higher volatility in the broader market. This is indeed what we saw from late January through early February as the market (VTI) experienced a peak-to-trough decline of -6.2%.

As you can see from the chart below, the rotation in the Utilities (XLU) sector preserved capital during this decline, and at the trough, in early February the market (VTI) was down -5.4% on the year while the ETF BRS was up 3.1%.

intermarket capital management image

After alternating between Utilities (XLU) and the market (VTI) from late February through March, the ETF BRS entered April once again defensively positioned in Utilities (XLU). It remains to be seen if this defensive positioning sticks and is again an indicator of increased market stress or if it turns out to be more temporary. And this is an important point. As I wrote in a recent post, a defensive rotation for us is not a prediction of a top or “the” top every time it occurs; for sure, no such “holy grail” exists in the markets.

Utilities leadership is merely an indication that risk in the equity market is rising. By respecting long-term probabilities, a more defensive positioning is warranted. For certain, there will be times when this defensive positioning proves to be wrong and remaining in higher beta positions would have been preferable. But again, just because you got home safe after driving while intoxicated, it doesn’t mean it was a good idea.

Regardless of whether heightened volatility occurs here and now, the wide outperformance of the Utilities sector on a year-to-date basis is certainly alarming, and likely indicative of a larger correction in the coming months (for other factors likely pointing to higher volatility this year).

XLU

We hope that you enjoy reading the paper. The behavior of the Utilities sector is one component of our ATAC rotation strategies. We look forward to providing further insight into our quantitative investment process in the coming months.

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