Revealing ATAC: Trading Small And Large-Caps

| About: iShares MSCI (EEM)

"There's only one growth strategy: work hard." - William Hague

Stocks in the US closed 2013 in a historic way, and started 2014 with a thud. The first trading day of the year saw some heavy declines globally. Some attributed the decline to tax selling, but the biggest drops occurred in those areas of the stock market which were down in 2013, with Gold (NYSEARCA:GLD) being the notable exception. Anecdotal evidence points to meaningful short selling in global equities. Emerging market stocks in particular saw heavy volume in many Exchange Traded Funds, with the largest emerging market ETF (NYSEARCA:EEM) trading more heavily than the S&P 500 ETF (NYSEARCA:SPY) - a relatively rare occurrence. While we continue to believe that a powerful move up will come, the momentum is simply not there in the near-term. Valuations make BRICs an investment. Momentum, however, does not yet make them a trade.

If indeed the selling on the first two trading days of the year was more short-oriented in global equities, than there may be a setup for a short squeeze to come. Furthermore, if Gold's advance turns out to be more than a bounce and more indicative of bets on negative real rates, then it furthers the case for allocating to non-US investments. Gold tends to perform well when expectations for negative real rates are rising. Those expectations may only heighten in the weeks to come. With vehicle sales surprising negatively, Europe's deflation becoming more entrenched with corporate borrowing collapsing, and Yellen replacing Bernanke, inflation expectations may soon rise and pull with them true reflation trades.

With that said, let's continue along with part 3 of the 5 part series on "revealing ATAC." In the first writing, I showed how a constant beta strategy rotating around the Dow Jones Industrials Average and Dow Jones Utilities Average could far outperform a buy and hold of both when considering dividends and time at risk. In the second writing, I showed how using the behavior of Consumer Staples to time credit risk could enhance risk-adjusted returns. This time, we'll keep things relatively simpler by doing a straight-forward backtest of rotating around small and large-cap stocks based on which is outperforming.

  1. Download weekly price data of a small-cap stock fund and a large-cap stock fund. In this simulation, I used NAESX as the small-cap fund, and VFINX as the large-cap fund.

  2. Create weekly returns for each

  3. Create weekly price ratios using small-caps divided by large-caps

  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 buy small-caps. If negative, you buy large-caps.

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

  8. Calculate overall return.

To see the chart, click here.

Note that going back to 1991, the rotational strategy outperforms both small and large-caps up until around 2003, stays in line with small-caps up until around 2009, and lags small-caps since while continuing to outperform large-caps the entire time. On first glance, one might think the rotational strategy has no merit as an approach given the last two plus decades. This, however, completely ignores risk-adjusted returns, which is slightly higher than a buy and hold of small-caps. In other words, the ride is smoother for the rotational strategy than holding small-caps overall, with returns that are quite strong over time relative to that risk. 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, talking about how a quantitative strategy focused on emerging market rotation can enhance overall returns over time, and volatility metrics. These writings will serve for us as a framework for white papers we are putting together to provide a more academic look into why we developed our strategies the way we developed them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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.