Revealing ATAC: Adding An Emerging Markets Variable

| About: SPDR S&P (SPY)

"You don't get paid for the hour. You get paid for the value you bring to the hour." - Jim Rohn

The S&P 500 (NYSEARCA:SPY) staged a nice rally Friday, particularly in the emerging markets space as long bonds ripped higher in price, yields dropped, and bets on further tapering were, for lack of a better term, tapered. Weak payroll data shocked the bond market (NYSEARCA:TLT), reminding those who argue that we are in a "rising rate environment" that deflationary pulses may still be permeating throughout the system. The Fed's minutes appear to be acknowledging that QE is ineffective and potentially causing excessive valuation in stocks, which adds to the point we made a few months back that the Fed would be naive to not recognize a potential bubble in the making.

One of our major themes this year is the idea that we may re-enter a negative real rate environment, whereby inflation is higher than nominal yields. Unless inflation picks up suddenly in a real way, the only way to get this done is through a drop in yields. Up until Friday, inflation expectations post taper were indeed rising, and the week over week trend remains intact. However, if poor job creation is a harbinger of things to come, then demand-pull reflation hope might reverse. Earnings likely serve as the real test for markets, given that over 25% of last year's stock market gains were driven on hope through P/E/ expansion. Should earnings confirm payroll weakness, P/E contraction may become more likely.

The move Friday in the bond market was sizeable, and the ratio of long to short duration Treasuries may be on the verge or staging an uptrend. That means the yield curve could begin to narrow, and cause long duration bonds to stage a period of outperformance relative to US equities. While our signal is not there just yet, it does seem plausible that the market expects either a slower pace of tapering, or even more stimulus should things deteriorate on the economic front, especially against the backdrop of a US market which by many valuation metrics is highly stretched. Next week will likely provide real clarity. Regardless the two most hated trades are bonds and emerging markets. Such hatred is simply unwarranted. I have said this before and it bears repeating: bonds have priced in reflation which is non-existent. Emerging markets have priced in a crisis which is non-existent. US stocks? Well - those are taking after the honey badger by seemingly not caring about a thing (yet).

This is now part 4 of the "Revealing ATAC" series. In last week's writing, I presented a simply rotation backtest based on moving between large-cap and small-cap funds depending on relative outperformance over a rolling 4 week basis. I showed that the rotational approach does not beat small-caps over a 20+ year period from a buy and hold perspective, but it does present slightly better risk-adjusted returns. Now - what if we add a third variable to our rotation? Using the same methodology as outlined in prior writings, we can test a rotation around US large-caps, US small-caps, and emerging market stocks, all while maintaining constant equity exposure. The rule here is simple - if emerging markets are outperforming small-caps, position to emerging markets. If small-caps are outperforming emerging markets, position to small-caps. If neither small-caps, nor emerging markets are outperforming US large-caps, rotate only to large-caps as the default option.

Same methodology outlined in prior emails, but this time adding emerging markets to the mix. See the chart below, and note that by adding emerging markets to the mix, the rotational strategy far outperforms.

The fund used as a proxy for emerging markets here is the Fidelity fund FEMKX. Strength should not come as a surprise. For the most part, emerging markets really began pulling away from the US between 2003 and 2007, keeping relative momentum intact as the rotational strategy stayed exposed. Following the 2008 crisis, it was US small-caps which took the lead, which means that the average time spent in emerging markets was less post crisis, whereas before it was more. The longer-term performance then captures large cycles where spread outperformance persisted.

As I have done with others, if you are a financial advisor interested in seeing how this was created, please feel free to reach out to me directly. Next week I will introduce the idea of rotating around stocks and bonds building up to what I've presented thus far to provide a deeper sense of what the ATAC methodology at its core is all about. Might be good timing given that bonds may soon make a surprising return to leadership.

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.