On Discipline And Whipsaws

Includes: IWM, SPY
by: Michael A. Gayed, CFA


Treasuries whipsaw back.

Small-caps crater in way that breaks relative momentum.

The Not-Everything Boom has still left out emerging markets.

"There is always a disposition in people's minds to think that existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one which make it unlike its predecessors and give assurance of permanency. The one fact pertaining to all conditions is that they will change." - Charles H. Dow, 1900

For nearly four years, we have been running client assets on our ATAC absolute return models, often referred to as our inflation rotation strategies. For those unfamiliar, this particular strategy was designed from day one to be an uncorrelated, absolute return approach to generating portfolio performance. Every single week, market prices are used to determine if the conditions favor risk taking in stocks or risk taking in Treasuries, rotating fully into equities or fully into Treasuries based on probabilities. Traditionally, when conditions do not favor equities, they tend to favor Treasuries (often referred to as "risk-off" behavior although Treasuries themselves carry risk). Once the asset class decision is made at the end of the week, the model on the equity side will rotate either into US large-caps, US small-caps or emerging markets based upon relative momentum. If the decision is Treasuries, it's a function of choosing the duration of Treasuries on the yield curve which have the most favorable momentum.

Again, this is done on a weekly basis, rotating aggressively either into large-caps, small-caps, emerging markets, or Treasuries based on our models which we give voice to in various writings and commentaries on markets. Our quantitative models are robust, using methodologies similar to those outlined in the 2014 Dow Award winning paper "An Intermarket Approach to Beta Rotation" which can be downloaded by clicking here, and the 3rd Place Wagner Award winning paper "An Intermarket Approach to Tactical Risk Rotation" which can be downloaded by clicking here. The two papers address the predictive power over large sample periods of Utilities (NYSEARCA:XLU) and Treasuries (NYSEARCA:TLT), both of which are directly used in our real-time live ATAC models. In a world of "alternatives" which still have a high correlation to beta, our inflation rotation absolute return approach effectively has a correlation of zero to broad equities, and historically flat to negative downside capture. This should make sense, since during stock corrections, the model tends to position assets into Treasuries fully out of stocks.

The inflation rotation strategy is not our only one, however. We also run a Beta Rotation model which is designed to be a pure, long-only equity alternative. Rather than rotating into stocks or Treasuries, the Beta Rotation model rotates fully into high beta cyclical sectors of the stock market, or fully into low beta defensive/dividend sectors of the stock market based on the exact same weekly trigger as the inflation rotation model. Every quarter, the weighting mix within the high beta basket and the low beta basked will shift based on longer momentum metrics. Currently, the Beta Rotation approach for the 3rd quarter heavily favors the Energy sector, taking a heavy overweight to that group when our weekly risk trigger favors taking on more risk.

I have outlined above all of this to provide context on our approach. That now brings us to this year, and the current "staircase up, elevator down" moment we experienced in our inflation rotation strategies. From a risk-adjusted return and volatility perspective, 2014 had up until the last two weeks been a particularly strong year for that particular strategy. While that strategy is designed to purposely NOT be correlated to stocks or bonds, it had performed in line with the S&P 500 (NYSEARCA:SPY) without anywhere near the same kinds of risks. We completely sidestepped the broad market mini-correction from mid-January to early February, actually going up as equities fell, and completely avoided the small-cap correction which happened soon afterwards.

However, no strategy is foolproof, and all approaches are susceptible to whipsaws. We entered July being long duration Treasuries given relative momentum there and our risk trigger saying the odds favored risk in bonds as opposed to risk in stocks. Treasuries fell as equities rose in a meaningful way that week, with stronger than expected payroll data making it look likely that Treasury weakness would persist. This pushed our inflation rotation assets out of Treasuries (taking the loss) and into US small-caps (NYSEARCA:IWM). This was done because 1) the risk trigger flipped to equities, and 2) among the opportunity set, small-caps had the strongest relative momentum.

Last week, small-caps suffered a sharp decline relative to large-caps in a stunning way, at the same time Treasuries effectively "V-ed" right back as if the prior week never happened. The sharp decline down in small-caps following the loss in Treasuries caused the inflation rotation model to give back all of the year's gains in two abnormal weeks of volatility for both Treasuries and small-caps. At the end of last week, the trigger kept us in equities, but caused us to sell out of small-caps, taking the loss there as well. Effectively, the last two weeks resulted in sharp whipsaw declines.

The Beta Rotation strategy went through a different issue. Recall that our equity sector rotation strategy does not position into Treasuries or equities, but rather is constant equities rotating around high beta and low beta sectors. During the first week of July, that product entered the month fully exposed to Healthcare (NYSEARCA:XLV), Utilities, and Consumer Staples (NYSEARCA:XLP). Utilities in particular sold off incredibly sharply during the first week (similar to Treasuries) and recovered strongly the following week (again similar to Treasuries). In addition, Oil prices (NYSEARCA:USO) cratered in a nasty way over a few short days, causing the Energy (NYSEARCA:IYE) sector to underperform. This weakness from a sector standpoint caused the Beta Rotation strategy to not perform as well as the S&P 500 last week, though it certainly held up better than the absolute return performance pattern of the inflation rotation approach.

And yet, despite these whipsaws, we are undeterred. We trust in the process, trust in the approach, and trust in history. Every single strategy has the potential to undergo a staircase up/elevator down moment. People have forgotten that the S&P 500 can easily go through this too. It simply has been so long of an outlier period that no one seems to think that is possible. Any casual observance at how markets behave historically shows this is simply not true. In our case, the last two weeks were the staircase up/elevator down moment for us. That does NOT at all mean the strategies are not working given our historical testing.

As to what happens next, we do believe the environment will favor tactical rotations and that the high correlation of Treasuries to equities will break down. European financials are not well, US small-caps are not well, and high yield junk debt is fragile to a run. The New York Times has coined this the "everything boom." They are wrong. Emerging market stocks (NYSEARCA:SCHE) have not boomed whatsoever, despite emerging market credit spreads for the first time in a long time performing healthier than credit spreads around the globe. When US small-caps corrected pre-June, emerging markets rallied in a way that has never happened before in history. If large-caps in the US correct, we may yet see the same type of uncorrelated behavior where emerging markets finally break through their multi-year trading range and become the uncorrelated asset.

Finally, it's worth noting how a strategy that rotates between Treasuries and stocks can perform during more normal periods like 2012. A casual look at how long duration Treasuries rallied from April 2012-early June 2012 shows that they outperformed the S&P 500 by around 3000 basis points (30%) in a two month period. We know this can happen again, which can make the longer track record seem like a moot point in the blink of an eye because we, unlike others, have the potential to make such a full and aggressive rotation. We maintain our discipline because at the end of the day, that is the only winning strategy over time.

The one fact pertaining to all conditions is that they will change. So too will ours.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has 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.