“The best way out is always through.” – Robert Frost

Traveling the country over the last several months has been a fascinating experience for me on a personal and professional level.  I’ve interacted with thousands of financial advisors and individual investors, all of whom have showed interest in our award winning research which I present to Chartered Financial Analyst (CFA) and Market Technicians Association (MTA) Chapters in several states.

The title of that presentation is “Generating Alpha: Predicting Volatility and Corrections,” a topic which is of particular interest to financial advisors since emotional responses by clients get heightened during periods of heightened price fluctuations.  In it, I discuss our findings in the 2014 Dow Award winning paper “An Intermarket Approach to Beta Rotation” which shows the remarkable predictive power of the Utilities sector. Afterwards, I then go into detail about the signaling power of Treasuries, which is what the 3rd Place Wagner Award winning paper “An Intermarket Approach to Tactical Risk Rotaton” documents. In the case of both Utilities and Treasuries, their movement tends to precede periods of heightened market volatility, and leadership tends to historically occur right before a stock market correction takes place.

Most risk managers in this business fail at managing risk because they tend to do so post, not pre.  The idea of tracking the behavior of Utilities and Treasuries is that historically, from a quantitative and unemotional standpoint, their outperformance tends to tell you beforehand that a regime change in volatility is coming, given their extreme sensitive to growth and inflation expectations.  In Portland, Oregon last week, I was asked by an attendee of the presentation how many false signals Utilities and Treasuries give in terms of predicting volatility.  My response?  A lot – and that is EXACTLY why a strategy focused on those two areas works over time.  The best strategies over time are the ones with the most false positives.

The crowd looked at me curiously.  Why was I saying this?  Well let’s think about the other side of the issue.  If someone has a strategy that tries to take advantage of a market anomaly, and signals are right every time, how do investors react to the hot hand?  Simply put, they allocate assets to it.  The hot hand continues to take advantage of the anomaly, until at some point there are so many people chasing that successively right number of signals that the anomaly becomes arbitraged away and no longer exists.

My point here is that there MUST be disbelief in a signal in order for an anomaly to persist.  There must be doubt that the signals work, otherwise if everyone believes in it, sticks to it, and trades off of it, the phenomenon that signal is trying to anticipate fades away.  It is perfectly okay to have false positive nine out of ten times, so long as the magnitude of the tenth time swells those of the nine others.  Nearly all traders, and investors, however, care only about the streak and successive number of wins, rather than the magnitude of them and the potential to get a massive trade right based on conditions that favor tail events (which Utilities and Treasuries once again historically warn you of).

I’m writing all this because it is important to understand what we do in the context of how markets work.  Our entire approach for both our alternative inflation rotation strategies and our equity sector beta rotation strategies is based largely on the predictive power of Utilities and Treasuries (alongside other inputs).  Whenever in my writings I’ve used the term “deflation pulse,” that was simply a way of describing the strength in Utilities and Treasuries.  In our uncorrelated inflation rotation strategy, the responses to predictors of volatility leading is to go into the only asset class that tends to benefit from stock market volatility, which is Treasuries.  That’s why we go all-in to Treasuries when those areas tell us to.  In our equity strategy, the response is to go all-in to the most defensive, dividend-heavy areas of the stock market, which are Utilities, Healthcare, and Consumer Staples.  The idea is that when conditions favor volatility for stocks, if you must be in stocks, then you want to at least be in the least sensitive stock market sectors within that volatility.

If your whole approach is designed to rotate around historically tested signals of coming volatility, but no volatility ever comes for a prolonged period of time, what do you do?  The answer is simply that you continue doing what you are doing.  At some point volatility returns, and discipline becomes rewarded.

That brings me to the action last week. Japan, simply put, is out of its mind, and the vicious V in high beta equities may mark a near-term extreme from which it reverses. As mentioned by Todd Callaway on Twitter in a message sent to me, “the S&P 500 rallied 14.4% in 7 days to mark the 1,553 top on 3/24/2000.” This most recent move has been nearly as violent in terms of speed and magnitude, with Japan’s shock and awe stimulus announcement Friday only adding more fuel to that pattern. Yet, defensive sectors did not give at all into the V move higher, and Treasury yields have not confirmed the excitement in stocks. The world is cheering the end of Quantitative Easing and failing to see failed reflation. The world is cheering Japan’s stimulus, failing to see that stimulus for equities is not stimulus for the economy. I personally have no problem in our inflation rotation alternative strategy missing the right side of the V, given that we largely missed the left side of it too. The beta rotation strategy V-ed, and generated nice alpha from its own sector positioning in October.

Where this ends, no one knows. We continue to follow our quantitative strategies regardless of the narrative of the day, because we trust in history, cause and effect, and our award winning research. Fellow co-author of those papers and Director of Research Charlie Bilello put together a nice chart to remind period of just how violently equities have tended to underperform Treasuries post QE programs ending. Will history repeat?

History shows you can predict stock market volatility and corrections, but not vicious V formation like this most recent one.  That’s okay – these tend to be rare.  If you want to have a strategy which works beyond the small sample, you must look at large data and historical movement.

Sincerely,
Michael A. Gayed, CFA