Politics, Cycles And Mean Reversion

| About: SPDR S&P (SPY)

When the time comes and the evening darkness provides some cover, the infant turtles start their scramble up from the sand nest. The wiggling mass of 70-100 hatchlings causes the sand to collapse and makes their task even harder. But nature has a grand design. The falling sand raises the floor of the nest so the baby turtles can reach enough elevation to exit.

A few hours later, baby turtles pour from the nest and crawl at once toward the waves. About 1% of those born in the sand of Tortuguero's beach on Costa Rica's Caribbean coast will survive the many miles of swimming to the grassy mass that can hide them and feed them. Years and thousands of ocean miles later, those females that avoided fishing nets and predators will return to lay eggs. The males will mate with them in the surf but remain in the water.

Mean reversion of cycles takes many forms on this fascinating planet we inhabit.

The challenge of behavioral finance has always been to estimate mean reversion tendencies and quantify them where we can. The baby turtle grows and survives or gets trapped in a net or eaten by a predator. In financial markets, too, we see both traps and predators.

In past months we have written repeatedly about 2016 as the year of politics. We argued that market agents' responses and reactions were the stuff that would drive financial price volatility. Furthermore, we argued that clues about buying and selling were obtainable in some market-pricing metrics. In February we focused on potential volatility trends in the coming months, and in July we analyzed US and global political trends and their investment implications.

At Cumberland, we follow market-pricing metrics daily. They help us make buy, sell and hold decisions in the portfolios of bonds and ETFs that we manage for our clients. Those metrics also help us establish weighting and identify turning points. All this is needed for successful portfolio management.

On the second day of the Brexit sell-off, the stock markets of the world and certainly the US had an extreme negative reaction that indicated an entry point. Fear was driving prices, so that the likelihood of a major asymmetry was at hand. We acted based on estimates of US market overreaction to the negative surprise. We became fully invested.

In the recovery period in the later summer, our quantitative work started to suggest that caution was advised. The asymmetry had shifted from fear to complacency.

Meanwhile, the post-Brexit bond reaction in mid-July suggested bond yields were making a massive bottom and bond prices were at extremes. We had already been in a duration-shortening mode for months, but my colleagues in the firm's bond section felt the need to pick up the pace. As John Mousseau likes to say, "Feed the beast when it wants to eat." The markets were hungry. We took profits.

For bonds, the yield on the 10-year US Treasury hit a low of 1.3% in mid-July and is now almost 1% higher. As for stocks, interest-sensitive sectors like Utilities have been hurt badly. We dodged both bullets. The question is how.

Sometimes it's just plain luck. Other times, paying attention to traditional valuations works. And of course our quant guidance is important. When all factors align, it becomes easy to act with high confidence.

This leads us to discuss the uniqueness of the Trump market volatility.

In the two weeks preceding election night, the fear of a Trump victory twice led markets to experience extreme panic. The ebb and flow of Clinton versus Trump was reflected in stocks, some commodities, and foreign exchange markets like the Mexican peso and the Japanese yen.

So our quant work, which is dynamic and captures estimates of regime changes, was indicating the metrics we needed to see in order to act in the event of a regime change. Then came election night.

US markets were closed. US securities trading in foreign markets experienced a third extreme. This, with the previous two panic selling events, created a nearly unique condition, a validated triple bottom. We think of it as a "confirmed global triple bottom."

Not only had the US sellers of stocks become exhausted, but sellers in the rest of the world had too. US stocks were massively oversold. The only thing to do was to be 100% invested. In many accounts we were already well-positioned, and we completed the rest, including our two volatility-based strategies. As this is written, we are still fully invested in US stock market managed ETF portfolios. But a change may occur at any moment.

History suggests that there is more upside ahead. Over the last century Republican dominance in the White House and Congress has produced strong nominal and real (inflation-adjusted) results, averaging close to 7% annually.

Will the Trump markets match or exceed history? We will find out. But our quant metrics say we haven't reached the complacency stage yet. Daily evaluations are needed since change may occur at any time. And valuation estimates are adjusting for higher inflation, larger deficits, expansive fiscal spending on infrastructure, lower taxes and diminished regulation. That is a powerful stewpot cooking. It is heating up from a global triple bottom.

As with the sea turtles, investment cycles are measured in years, and this era is just starting. Currently, we're just seeing a sentiment adjustment and an expectations shift. So behavioral finance again holds the key to translating market movements into strategy shifts. Our dynamic quant work continues to inform our decision-making.

At this moment we remain fully invested in ETFs in the US market. Although change may come at any time.

We are nibbling slowly and selectively in sections of the bond market that have been violently beaten up. And we watch daily for shifts in regime-changing metrics.