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"You have to learn the rules of the game. And then you have to play better than anyone else." - Albert Einstein

The S&P 500 (NYSEARCA:SPY) continued their upward advance as China (NYSEARCA:FXI) held back emerging markets (NYSEARCA:EEM) in the final trading sessions of 2013. The 10 year Treasury yield (NYSEARCA:IEF) rose above 3%, in what appears to actually be healthy behavior occurring in the bond market. Unlike the prior yield spike which sent rates briefly over the 3 handle a few months back, this move coincides with what may be the real start of a trend higher in inflation expectations. As we have noted, rising inflation expectations are precisely what a healthy risk-taking environment needs historically, and could keep a bid under overall beta into January.

The Fed may have gotten its wish as intermarket relationships begin to legitimately normalize beneath the market's surface. Global cyclical sectors are beginning to show some signs of life, and most emerging markets (except China) appear not only to have bottomed relative to the S&P 500 on a price ratio basis, but are showing real signs of leadership. Russia and India in particular look attractive, and once unwarranted fear over an engineered "credit crunch" in China goes away, it should be all systems go. If the deflation pulse is indeed over because QE was the source of deflationary pressure, then tapering brings back historical correlations. That should result in a resync of everything else around developed equities. The year 2014 continues to look more and more like the year of the "Great Convergence" which results in commodities getting a bid, and emerging market stocks entering a bull market.

With tapering comes normalization, and significant opportunity for next year. There is an unequivocal opportunity in emerging market stocks once momentum returns relative to the S&P 500. Unlike in May-June when tapering was first brought up and emerging market debt collapsed, this time around there is real strength occurring on the sovereign paper side. Because credit tends to lead equities, this is likely extremely bullish. The price ratio of EMB to IEF (Emerging Market Debt to nominal 7-10 Year Treasuries) is basically back to mid-May levels. Meanwhile, the ratio of EEM to SPY (Emerging Markets to the S&P 500) is no where near it. If the EM equity ratio went back to mid-May levels as the EMB debt ratio has, that's the equivalent of around 22% outperformance. That means if US stocks go up 10% next year, broader emerging markets end up over 30%. The potential performance becomes even more extreme should the market want to undo the entire spread against US markets that happened in 2013.

With all that said, let's continue along with part 2 of the 5 part mini-series on "Revealing ATAC." In my last writing, I showed a "simple way to destroy the Dow" with a backtest going back to 1929. By being constantly exposed to beta and rotating around Dow Utilities or Dow Industrials based on rolling outperformance, total return and risk-adjusted metrics were greatly enhanced. Our current ATAC models used for managing our mutual fund and separate accounts use multiple inputs, but I want to highlight here yet another important relationship which has predictive power.

So let's do another simple backtest which would result in constant bond exposure instead of constant stock exposure. This time, we'll use stock behavior as the trigger for bond rotation. Again - not a market timing approach since market timing is between an asset class and cash. Rather, in this simulation the rotation is between high quality/AAA bonds and high yield corporate "junk" debt.

1) Download weekly price data of a AAA bond proxy, a junk debt proxy, a Consumer Staples equity sector proxy, and a stock market proxy. In this case, I used the Vanguard Total Bond Market Fund, Vanguard High Yield Bond Fund, the Fidelity Consumer Staples Mutual Fund, and the Vanguard 500 Index Fund.

2) Calculate weekly returns of each.

3) Create weekly price ratios using Consumer Staples divided by the stock index proxy.

4) Create a 4 week moving average of the ratio.

5) Create a rate of change calculation over the prior two weeks of the moving average

6) Make a rule such that if the rate of change calculation is positive, you hold 100% the AAA bond fund. If not, you hold 100% junk debt.

7) Factor in a commission/slippage assumption on every rotation/trade (assumed 0.1% in below simulation).

8) Calculate overall return.

Here's what it looks like.

(click to enlarge)

On first glance, going back to 1990, this may not seem that impressive. The rotational strategy that rotates to lower volatility AAA when Consumer Staples outperform the S&P 500 and rotates to junk debt when its not looks like the junk debt fund over time. In the 1990s it underperformed a buy and hold of junk debt while outperforming AAA. In the past 12 years, it outperformed both, and very recently junk debt on a total return basis has caught up with the rotational strategy.

However, this thinking completely ignores time at risk, and volatility. Approximately 52% of the weeks in the above simulation are spent in AAA, while the remaining in junk. The standard deviation of the rotational strategy is 12% higher than a buy and hold of AAA, and 25% less than junk debt. It is so often forgotten that a big potion of being "in the game" is not being shaken out of the game by the emotional response that occurs during periods of higher volatility. Because in this case volatility is less than a buy and hold of junk debt alone, the rotational strategy's risk-adjusted returns are considerably higher than a buy and hold of either credit exposure over time. This in turn makes the ability of one staying in the strategy higher than staying in junk debt which has historically had meaningful drawdowns.

Consumer Staples (NYSEARCA:XLP), like Utilities (NYSEARCA:XLU), is a low beta/high dividend sector which tends to outperform broader equity averages during periods of volatility, corrections, recessions, and deflation. It stands to reason then that as money seeks safety due to common factors in equity relationships, so too will it do the same on the debt side of the equation. As noted before, I am happy to show how the calculations were done for the above to financial advisors only. If you are one, feel free to reach out.

Next week I will continue with the "Revealing ATAC" series, and look forward to what 2014 brings. From all of us at Pension Partners, we wish you a safe, happy, and healthy New Year.

Source: Revealing ATAC: A Better Bond Strategy

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.