“Two roads diverged in a wood and I – I took the one less traveled by, and that has made all the difference.” – Robert Frost

Whenever I see headlines that read “stocks hit new highs,” I tend to cringe. Stocks are not hitting new highs. A particular index, the S&P 500, is. The German DAX has not for some time. The French CAC has not. Brazil has not. China has not. US small-caps have not. Yet, in a world where people are more interested in the headline rather than the content, it certainly feels like an incredible bull market in stocks. Sentiment surveys prove this given extreme optimism, when the reality is that most stock markets globally beyond US large-caps simply have not participated this year.

Friday, the “stock market” surged as investors cheered Draghi saying the same thing regarding doing whatever it takes to spur Eurozone inflation. The market rallies on words and not actions, and seems to forget that even if the ECB did Quantitative Easing, no round of QE caused inflation in the US, nor in Japan. The utter insanity of the current environment is the belief that 1) central banks are omnipotent, and 2) that they can cause inflation with bond buying despite screaming historical evidence that says otherwise. Manipulating markets in the name of the wealth effect only creates wealth inflation in the top 1% who hold assets, and not for the rest of the population which relies on income.

Having said all that, I think it’s important to address something which is underappreciated when it comes to the business of portfolio management. Too many focus on market levels and targets, rather than the path to those levels and targets. One of the hallmarks of the QE3 environment has been intermarket behavior which diverged substantially from historical relationships. This is well documented as it relates to the relationship of stocks to bonds to inflation expectations to commodities and to currencies. Any kind of a risk trigger has not mattered for US large-caps, and correlations have veered far away from average levels history suggests are reliable.

All active strategies, whether they are between asset classes or within them, are ultimately path dependent. To create a strategy that takes advantage of the most likely path, one needs to look at decades of market history beyond the small sample we all live in. That is precisely why we wrote our award winning papers on predictors of stock market volatility and corrections. The good news is that the path is normalizing. Our equity sector beta rotation strategy has fared strongly in the fourth quarter thus far rotating fully into defensive sectors all-in during October, and out of them all-in to cyclicals in November based on our risk trigger. That same risk trigger used in our inflation rotation strategy between equities and Treasuries continues to serve as an uncorrelated return stream in a portfolio, but relationships between the two asset classes are not as quick to normalize as those across stock market sectors.

What would normalize the relationship between the two likely would be a sustained correction in stocks that lasts more than two weeks as was the case in October. This remains a distinct possibility in December given that every end of Quantitative Easing resulted in a stock correction one month later. Utilities and Treasuries based on our models (alongside other inputs) are nearing another risk trigger flip. If this does not take place, cyclical sectors likely continue to show signs of strength, confirmed with emerging markets which may finally show some sustained leadership in the months ahead. While the world has focused only on return, the reality is that over time managing downside risk and stock market volatility is far more important to wealth generation over several years than chasing an outlier. Well known and storied alternative funds which have been considered among the best in the industry know this full well given that the entire asset class has been under attack for not keeping up with stocks. Funny how no one wanted alternatives in July 2007, and everyone wanted them in 2009.

Regardless, we continue to be excited for the future and the return of sustained volatility outside of the small sample outlier are living in. To that end, our two main strategies, designed to take advantage of predictors of that volatility in two different ways, should benefit from that on-going normalization.

Sincerely,
Michael A. Gayed, CFA