Weekly Fund Wrap: Long Live Late Cycle

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Includes: AMLP, BIL, BKLN, CEW, CMBS, CWB, DBB, EEM, EMB, EMLC, GLD, GOVT, IPE, JNK, LQD, MBB, MUB, PFF, SPY, USO, UUP, VNQ
by: ADS Analytics
Summary

The government shutdown came to an end with the Congressional Budget Office expecting a permanent loss of $3bn to the US economy.

Markets were mostly unchanged this week as the risk-on rally appears to be petering out with investors looking for further cues from the Fed and trade talks.

We continue with our tactical theme and expand our ETF momentum strategy to the closed-end fund space.

The US government shutdown has ended as President Trump signed a reopening of government for an interim period. The CBO calculates the shutdown cost the economy $11bn, $8bn of which is expected to be recouped.

A Chinese trade delegation arrived in Washington on Monday for an additional round of trade talks. The US side does not appear hopeful of making a breakthrough while emphasizing the need to make progress on this piece of the administration's agenda.

This week, we introduce a momentum strategy for CEF sectors. All of the three strategy versions have outperformed an equally-weighted sector portfolio. Currently, of the five long positions, the strategies agree on being long all three mortgage sectors (agencies, RMBS, and CMBS) while disagreeing on the other two. The best-performing strategy is long CLOs and Convertibles.

Macro

Initial claims for the third week of January fell below 200k, the lowest level since 1969. The Fed December Leading Economic Index declined 0.1% due to market turbulence during the month.

Due to the previous government shutdown, the data for durable goods orders and new home sales for December is still unavailable.

We will have a fuller picture of the US economy and the impact of the shutdown once the full suite of data starts coming in, but the current picture remains one of a gradually moderating economic growth and activity. This has not yet been a threat to the market which is laser-focused on communication from the Fed and the Chinese trade talks.

Source: ADS Analytics LLC, Bloomberg

Markets

The markets had a mostly uneventful week as the recent rally appears to be running out of steam. Risky assets were supported by dovish ECB comments as well as news of a Chinese stimulus and mostly did not react to the news of the end of the government shutdown.

Source: ADS Analytics LLC, Bloomberg

CEF Space

Closed-end funds mostly followed the ETF lead with equity and oil-linked sectors underperforming with defensives and fixed-income sectors outperforming. NAVs mostly rallied on the week while discounts were mixed.

Source: ADS Analytics LLC, Bloomberg

Late Cycle

It is at least two years that we remember the term "late cycle" being bandied about by the market commentariat. One obvious data point is the sheer length of the current economic expansion which is the second longest on record and a mere six months away from a record.

Source: KKR

Of course, expansions don't die of old age and so we need more information to determine which part of the cycle we are likely to be in. We have come across three different rules-of-thumb to help us in this regard:

  • "gravity" - this rule suggests that a slow-growing economy will find it easier to fall into a recession than a fast-growing economy. In other words, an economy needs to operate at a certain escape velocity, otherwise, it will tend to slow down even more until it falls into a recession. Previous recessions, particularly those not kicked off from sudden unexpected events like spiking oil prices do tend to follow this pattern. The recent month-long shutdown may very well lead to a further slowing down of the economy but so far macro data has been good enough to rule this out.
  • "data hodgepodge" - this is more of a checklist rather than a rule where historically we tend to see similar types of indicators preceding recessions such as peaking earnings, widening credit spreads, rising volatility, building inflation pressures, tightening financial conditions, and others. Many of these are indeed happening now but as we are coming off very strong 2017 levels, they do not appear to be threatening yet in absolute terms.
  • "imbalances" - takes the view that very little matters outside of key economic imbalances such as the ability of certain economic participants to service debt or for certain entities to hold unsustainable short-term borrowings. The current economic cycle is relatively free of these imbalances that may tip us into a recession.

So, our conclusion here is that while we may be in a "latish" cycle environment, we are not obviously in a very late cycle environment. This view, even if it is correct does not, sadly, help anyone trade markets because there is not a clean one-to-one link from a cycle stage to market returns. This is because a late cycle can see different market environments - for example, equities typically rally the hardest during a late cycle where behavioral biases such as euphoria and herding take center stage before collapsing quickly.

For this reason, there is lots of advice out there on how investors should position themselves. One approach investors can take, of course, is to ignore the million typewriter monkeys, open a bottle of wine and stream a good box set and we have a lot of sympathy with this approach. Another approach investor can take is to try to position themselves and try to squeeze some alpha from the market.

PIMCO write a lot of commentary on various market topics and they often wade into the late cycle debate which they did in a recent article. Two of their three recommendations, oddly enough, have to do with emerging markets, but the key advice is captured in the following extract.

We agree that embracing a more dynamic or flexible investment approach makes sense in today's markets, where buying "the beta" (i.e. the market return) may be less likely to work given a starting point of economic uncertainty and high valuations. A dynamic approach has the potential to take advantage of tactical opportunities without being beholden to rigid benchmarks or guidelines.

This recommendation jives with our own view that during a period of heightened volatility and cheap valuations, it is worth tilting somewhat towards a tactical allocation.

To wit:

  • we have recently discussed an intra-sector tactical valuation metric - discount sector spread - and shown that historically there has been a decent amount of alpha in this metric
  • we have commented on current sector discounts relative to their historic trading ranges as well as our favorite metric of sector yield percentile vs. Z-score
  • we have also published regular fund screens that track fast-moving tactical opportunities
  • finally, we have recently published an ETF momentum primer which is a systematic trading strategy that aims to capture trending winners and rotate out of trending losers

In this article, we expand the ETF momentum strategy to CEF sectors. We think a momentum strategy is a compelling core strategy across all trading environments because it relies on systematic behavioral biases and a clear economic rationale, however, it is particularly relevant now given increased uncertainty in the direction of the market.

In the chart below, we show three different momentum strategies and plot them against an equally-weighted portfolio of CEF sectors. The three momentum strategies are the following:

  • Momentum - 1-year gross price return
  • Momentum 1M Lag - 1-year ex-last month gross price return
  • Momentum 1Y MA - 1-year gross price return vs. 1-year moving average

Source: ADS Analytics LLC, Bloomberg

The strategies hold the best-scoring quarter of income CEF sectors and are rebalanced monthly.

These are the basic stats of the four strategies:

Source: ADS Analytics LLC, Bloomberg

Interestingly, the dynamics of the CEF market, specifically the tendency of discounts to widen during a sell-off, mean that no sectors are likely to show positive performance during a sharp sell-off. This means that unlike in our ETF article, CEF momentum strategies still suffer steep drawdowns. This, however, does not stop the momentum strategies from outperforming the equally-weighted portfolio - but they do this not only by somewhat limiting drawdowns but also by having the winners outperform by a larger margin than in the ETF space. We will have more to say about this strategy in the coming articles as we continue to flesh out our systematic strategy suite.

Conclusion

The recent period of heightened volatility and ongoing debate around a late cycle is causing many investors who closely follow markets some serious whiplash. One approach investors can take to mitigate and take advantage of behavioral biases that increased volatility can exacerbate is to move to a more systematic allocation approach. Momentum is one such strategy - the best-performing version of the strategy has outperformed an equally-weighted portfolio by 2% per annum with lower volatility. While this strategy still suffers serious drawdowns and is naturally not guaranteed to outperform, we think it is worth a look.

Disclaimer: This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor. Although information in this document has been obtained from sources believed to be reliable, ADS ANALYTICS LLC does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. ADS ANALYTICS LLC does not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.