“Yesterday is a cancelled check. Today is cash on the line. Tomorrow is a promissory note.” – Hank Stram

Stocks in the US had their first positive week of 2015 as investors cheered what was already known to be coming – Quantitative Easing from the European Central Bank. The 1.3 trillion dollar bond buying program, it is hoped, will reverse Europe’s deflationary funk and allow for a return to growth.  This predictably helped pushed European equities higher, as the German DAX index hit new all-time highs. However, this is coming at the expense of the Euro, which appears to be in utter free-fall. Similar to Japan, Europe’s strategy is to export deflation through a weakening currency. The insanity of this, however, is that it has not helped Japan’s deflation problem, and no round of Quantitative Easing has ever been proven to boost reflation sustainably.

The meme currently out there is that Europe QE is bullish for US stocks, as the “baton” of stimulus is passed from Yellen to Draghi. However, market action suggests otherwise. If indeed European QE continues to break the Euro, with the Dollar already as high as it is, it stands to reason that European QE could actually be quite bearish for US multinational companies and their earnings due purely to currency volatility and trend direction.  This is a nuance being entirely missed by the media and investors/traders when thinking about asset allocation, regardless of whether QE in Europe actually works or not in terms of boosting the economy as opposed to stock animal spirits.

Something very special is happening in 2015 – the return of logic. For the first time since the beginning of QE3 in the US, correlations appear to be reverting to historical levels. Defense plays are actually playing the role of defense rather than offense, and “risk-on/risk-off” behaviorally seems to have returned. Treasuries rally hard when stocks are volatile and fall, they then fall when stocks rise. However, when Treasuries fall on those strong up days for stocks, they do not do so particularly violently, suggesting that finally Treasuries are serving as a proper hedge. Our risk triggers have kept us in that part of the investable landscape in our alternative inflation rotation strategy which in three weeks has far surpassed most buy and hold averages across multiple asset classes. The magnitude of being correctly positioned in such a juncture can far swell the frequency of being defensive through false positives.

In the case of our beta rotation equity strategy also used in our mutual funds and separate accounts, the three defensive sectors of Utilities, Healthcare, and Consumer Staples have performed as they should, outperforming in the rally meaningfully in a short period of time relative to more volatile cyclicals. In my presentations done around the country (http://vimeo.com/115038674), I make it a point that alpha-generating strategies over long cycles do not generate outperformance by being up more, but rather down less. There have been few opportunities to be down less than equities because of the smoothness with which large-cap averages have rallied. One must assume the future is not the past, and that volatility in commodities, currencies, and bonds must soon filter to stocks.

We welcome that. Most investors who buy “up and to the right” tend to do so near the turning point because they see a chart and extrapolate a trendline into the future. They fail to take into account volatility around that trendline, and their ability to manage emotions that come from that. For strategies like ours, whether alternative or equity, that volatility is the right kind of opportunity for active rotations.

Best,
Michael A. Gayed, CFA