"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius
The S&P 500 (SPY) made new highs last week as the FOMC reaffirmed its $85 billion/month bond buying program and as decent payroll data was accompanied by upward revisions to February and March jobs numbers. Friday appears to have broken the trend in yield curve flattening for now as longer duration Treasuries (TLT) rose in yield rather strongly. Throughout the week our ATAC models used for managing our mutual fund and separate accounts were indicating a potential change was coming to our positions. On Friday, we rotated out of bonds and into stocks on intermarket confirmation.
"What!? You got into stocks after all this time!? You're buying the top!!!" It is fascinating to see how people think when we announce rotational changes to our backtested strategies which are based on academic research and our own proprietary analysis. There is a class of people who will say that our move into stocks is indicative of a top in equities. This of course completely ignores 1) how our weekly strategy operates, and 2) what stocks we rotated into. Because our models are run on a short-term basis, it is entirely possible a move from bonds to stocks gets reversed in the coming weeks given that everything we do is about being condition dependent and intermarket trend movement.
More so than that, I am pretty amazed that no one seems to realize that outside the U.S., equity markets have been far from stellar. A top in stocks? U.S. averages are at new highs and have rallied strongly, but the MSCI Emerging Markets Index is still down over 1.2% for 2013. There has been massive divergence between true growth and cyclical stocks relative to U.S. averages which have been led by defensive sectors and all the things which are not indicative of a bull market. Tom Lee of JP Morgan made the point last week that cyclicals have underperformed by the 8th most in history, a 3-standard deviation type event. If the next fat pitch is here, then a significant catch-up period for emerging market stocks, which we positioned into on Friday, may lie ahead.
There is something else though that I want to address here. We have been largely negative on stocks given the deflation pulse we have been stressing in writings and media appearances. We have been primarily exposed to bonds for 2013 because of this. We are very happy with our performance on that given the gains we've made on that trade with time at risk in equities considerably low thus far year-to-date. It is very easy to say with hindsight that stocks were destined to go higher. However, that assumes what markets have done this year is typical of market behavior.
This could not be further from the truth. Historically, when defensive, low growth, high dividend sectors lead the market, it precedes corrections on average. It didn't this time around (yet). That does not mean caution was not warranted. Generating returns is as much about investing as it is about risk management. Behaviorally, everything that leads in a correction has done so. If you think it is normal for markets to behave this way, you are ignoring that this is the first time in over 15 years U.S. stocks have not fallen by 5% from January to May and the Stoxx 600 has had an 11th straight month of gains (as per Barry Ritholtz). There is a temptation by those who are older to have wanted full and aggressive exposure to stocks after seeing gains in the S&P 500, failing to recognize that stocks are inherently riskier than bonds, and the context of this juncture. A repeated bet on advancing stocks given the same intermarket trend behavior that happened this time around would fail over time.
Whether our rotation will stick remains to be seen. If the yield curve is indeed about to steepen, then money at the margin could rotate from overbought defensive plays to oversold cyclical plays. Emerging markets (GMM) are the purest way to do that in the near term. Because our models are quantitative, we will simple play where the relative momentum is most promising on a week to week basis. This has been by many metrics one of the more unusual junctures for stocks, and looking at the Dow or S&P 500 in isolation of intermarket movement and historical internal behavior provides a false sense of confidence with the benefit of hindsight, and without considering risk. If you believe markets on average do well when deflationary behavior is underway, you will be sorely disappointed when looking at the data. We do not invest based on the outlier. We buy and rotate based on observed cause and effect.
I will be re-releasing my father's 1990 book on Intermarket Analysis and Investing this week in his honor, and to provide deeper context of our thinking for those following our work. I look forward to seeing comments and feedback on it.
Additional disclosure: 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.