Crashes In The Eye Of The Storm

by: Michael A. Gayed, CFA


Alpha is not generated from being up more but mathematically from being down less.

We are living in the eye of the storm for equities, and crashes are happening while in it.

The market has a funny way of hurting the most number of people when you least expect it.

"I learned more about the economy from one South Dakota dust storm that I did in all my years of college." - Hubert H. Humphrey

About a month after the end of Quantitative Easing 1 in 2010, Treasuries began outperforming the stock market. By the time that leadership was over a few short months later, Treasuries outperformed the S&P 500 (NYSEARCA:SPY) by 3000 basis points (30%). Defensive sector Utilities outperformed by 1200 basis points (12%). After the end of Quantitative Easing 2, a similar juncture occurred, resulting in Treasuries outperforming by 4000 basis points (40%) in an even faster period thanks to the Summer Crash of 2011. Utilities (NYSEARCA:IDU) beat by 1500 basis points (15%). We are now a little over a month in time following the end of QE3. The Treasury/stock ratio has just begun to move.

Those who have invested in or are watching our inflation rotation alternative strategies may be shocked if such a situation is about to occur again. Recall that our inflation rotation model rotates to Treasuries based on our risk trigger. What goes into our risk trigger are proven leading indicators of stock market volatility (click here). Should the post QE playbook work, an enormous spread could take place between Treasuries and stocks, which means massive strength in that strategy.

Alpha is not generated from being up more but mathematically from being down less. The vast majority of outperformance over time comes from missing large downdrafts in equities. It is precisely for this reason that the presentations I've been doing around the country focus on generating alpha through assessing conditions which favor stock corrections and volatility. In the small sample period of the last year and a half, there has been an abnormally long period of non volatility and smooth market behavior where every risk rotation to be defensive has either failed with hindsight as stocks moved higher, or the trigger worked as it did mid-January and early October, but only for two short weeks.

Those who invested in our separate account vehicle which adheres to the inflation rotation model will remember how significantly and violently their accounts outperformed equities post QE and during periods of normal volatility and risk. Shareholders in the mutual fund vehicle have not seen that yet because of launching in an abnormal period. That will change. The same applies to our equity sector beta rotation model, which primarily generates alpha by being only exposed to Utilities, Healthcare, and Consumer Staples when conditions favor high stock market volatility.

We are living in the eye of the storm for equities, and crashes are happening while in it. Oil has crashed, down 12% last week alone. Credit spreads are widening in a disturbing way, with Junk Debt collapsing. The VIX just had its second biggest weekly percent change in history. The FTSE erased 7 weeks of gains in 5 days. These declines are following a textbook post-Quantitative Easing script.

The market has a funny way of hurting the most number of people when you least expect it. No one thinks a shock decline in beta is imminent, whereby equities crater in the last two weeks the same way they broke in the first two weeks of October. No one thinks this can happen because it has never before happened in history, let alone in December. Yet that is precisely why Black Swans occur.

There is severe weakness happening everywhere. Our stance was never about being a perma-bear, but rather about being consistent in respecting the movement of inflation expectations which stocks have ignored. Nearly everything else is now waking up to that disconnect. Something historic may be about to take place

After months of remarkable consistency and no risk, the behavior of Treasury yields falling, junk debt collapsing, Oil crashing, VIX spiking, and insanely bullish sentiment sounds like the right combination for a tail event which few strategies look for in the way ours do by following proven indicators of volatility. A severe deflation pulse is beating. That is not opinion - that is based on the factual intermarket behavior of those areas of the investable landscape which matter most, and lead first.

Remember that when it comes to markets, frequency takes a backseat to magnitude. Remember to remember that before the magnitude takes place.

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.