"You have to be fast on your feet and adaptive or else a strategy is useless." - Charles de Gaulle
Normally on Sundays, I write about the week that was and focus on some macro trends to provide voice to our strategies. However, I thought this time I would provide something new in what will end up being a 5 part mini-series revealing some of what goes into our ATAC models used for managing our mutual fund and separate accounts. The challenge for us as a macro quant manager is in conveying our strategies without giving away what exactly goes into it. However, we have no problem revealing portions of the approach to provide those interested a sense of comfort in the inflation rotation methodology.
Having said that, let's first do a quick recap of last week. To the world's surprise, the Fed tapered on Wednesday, and the S&P 500 (SPY) surged. It was a fascinating reaction in many ways. Emerging markets (EEM) outperformed on the announcement, the equivalent of buying stocks on bad news. Wednesday appeared to be the start of a real change in emerging market behavior. Recall that in September, when the Fed surprised by not tapering, emerging market equities had a huge move higher far outperforming US averages. Now, the Fed tapers, and emerging markets once again led on the day of the surprise.
The good news, then, is that emerging markets appear to not be vulnerable to Fed moves. The bad news, however, is China's sudden "cash crunch" which the media calls the worst since June. China ADRs (FXI) broke down as short term rates spiked the most since 2011, but this does not appear at all to be related to the Fed. Rather, this is due to a "manufactured crisis" that the PBoC may be trying to engineer to clamp down on lending. Having said that, this is likely a temporary phenomenon. In the short-term, this has broken emerging market potential momentum, but we fully expect leadership to kick in sustainably in the first quarter past this noise. The reaction to the taper is more important from an investor psychology standpoint than not.
Now, let's get to it. At the core of our inflation rotation ATAC strategies is the idea that intermarket trends can provide a sense of underlying market expectations as beta acts with a lag. Our existing strategies primarily rotate around stocks and bonds based on whether certain intermarket trends suggest inflation expectations are rising or falling. When rising, stocks tend to outperform bonds. When falling, bonds tend to outperform stocks. This year has been a notable exception given the outlier nature of equity behavior. I have seen some argue with hindsight and small sample bias that there was no reason to be defensive on stocks this year. My response is that if you believe it is a good strategy to go into stocks when inflation expectations fall, please review the history of Japan and any other market over the past century.
We will not reveal precisely what our models do, but we will be pursuing an aggressive educational approach on the importance of paying attention to intermarket dynamics using actual backtesting. One of the things our ATAC models consider is bond-like sectors of the stock market. The most bond-like sector of the stock market is Utilities (XLU). Historically, Utilities tend to outperform when the yield curve narrows and interest rates drop. This is primarily due to the highly leveraged nature of the infrastructure required to maintain business operations. Earnings become largely driven not be demand (which grows at a minimal, non-cyclical rate), but more by the cost of capital. Old-school technicians such as Edson Gould would often track the behavior of Utilities for clues on market tops and bottoms.
So let's do a simply backtest going back to 1929 to determine if a rudimentary buy and rotate strategy based purely on the behavior of Utilities could outperform a buy and hold of the Dow Jones Industrials Average (DIA). This is not a market timing approach, as there is no time spent out of stocks and into cash. Here are the steps:
Download weekly price data of the Dow Utilities and Dow Industrials going back to 1929
Calculate weekly returns of each
Create weekly price ratios using the Utilities Average divided by the Industrials Average
Create a 4 week moving average of the ratio
Create a rate of change calculation over the prior two weeks of the moving average
Make a rule such that if the rate of change calculation is positive, you hold 100% Utilities. If not, you hold 100% Industrials.
Factor in a commission/slippage assumption on every rotation/trade (assumed 0.1% in below simulation).
Calculate overall return.
Here's what it looks like.
On first glance, doesn't really seem that exciting, right? Sure - the rotational strategy marginally appears to outperform a buy and hold of Dow Industrials. However (and this is a major major point), this chart does NOT included dividends reinvested. Why does this matter? Because historically, the bulk of the Utilities Average's total return is driven by dividends, and not price alone. Meanwhile, the chart shows only price and no dividends reinvested. Using the simply Utilities/Industrials rotational strategy, approximately 47% of the time going back to 1929 is spent in Utilities, with the remaining 53% in Industrials.
Think about this for a moment. While the return on a price basis appears to be the same, 47% of the time is spent in high dividend producing Utility companies with the assumption of no dividend reinvestment. Utilities dividends have historically been considerably higher than dividends coming from Industrials. That means by definition the strategy, once you consider dividends, far far outperforms a buy and hold of the Industrials Average. Do not underestimate this point. Meir Statman estimated in 1999 that if one were to reinvest the dividends of the Dow Industrials back into the Dow Industrials, the value of the Dow would be 652,230 (considerably higher now over a decade late since that study). For those curious, you can review this here.
Again, because the nature of Utilities is to pay out a substantial portion of returns in dividends, the fact that the Utilities/Industrials rotation spends 47% of the time in Utilities (capturing some of those higher dividends), and still on a pure price basis ends up outperforming Industrials tells you there is real power in paying attention to sector leaders and intermarket trends. The issue of course is that this is a constant beta strategy. Because Utilities leadership tends to coincide with bond market (mainly Treasury) strength, we purposely created our existing strategies to rotate into bonds and not defensive sectors to provide a more alternative/absolute return approach to our strategies, and to sidestep periods of big beta drawdowns. This year, again, has been an exception to any real macro quant strategy which outperforms over time, but history is on the side of cause and effect.
For financial advisors interested in seeing the Excel spreadsheet which the chart above was created, and who would like to learn more about the power of certain intermarket trends, feel free to email us directly. The time has come to reveal some of the ingredients that go into our multi-input ATAC models. This allows those who actively trade for themselves the ability to consider additional ways of generating returns, and provides clients a sense of why we do what we do. I plan on writing a more academic white paper on certain things we track early next year as well.
Happy Holidays to all, and thank you for your interest in our company. We look forward to next year, as tapering continues. Why? Because QE3 distorted many intermarket relationships which developed equities completely divorcing themselves from inflation expectations. By extension, it is logical to assume the gradual removing of QE will cause a resync.
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.