“History is a vast early warning system.” – Norman Cousins

Excuse my frustration, but whenever someone claims that they “buy low, sell high,” I roll my eyes.  I’ve been on the road for the better part of two months speaking with advisors, traders, and analysts presenting our award winning research to CFA and MTA chapters.  Absolutely no one I have met legitimately loves value.  The incredible majority of people in the business of investment management buy past performance and chase prices up, rather than bet on mean reversion where most gains (and losses) are made.  Too many people believe that buying 52 weeks highs is better than buying 52 week lows.  Perform an actual backtest on a strategy that buys 52 week lows and you’ll find that that strategy does better than chasing performance higher.

In last week’s writing, it was noted that in the 2014 Dow Award winning paper “An Intermarket Approach to Beta Rotation” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2417974) I co-authored, around 20% of the time the beta rotation approach underperforms the market on a rolling 3 year basis.  If you happen to launch a strategy real-time in that 20% of the time the strategy does not work, I’m pretty sure that’s considered value for a quantitative strategy.  Few understand this because we live in the small sample, while markets live in the world of long cycles and big data.  People don’t view that 20% of the time as THE buying opportunity, even though it is the transition to the 80% of the time it works where most performance can be made.  Often, by the time that environment is visible, most miss it.

This brings me to current markets, and the nature of our alternative, non-correlated inflation rotation strategies which execute in a different way than our equity sector beta rotation approach.  Internally at Pension Partners, we’ve been joking that we don’t want anyone to invest in our strategies unless they read our two papers, both of which independently discuss inputs that go into the “risk trigger” that causes an all-in switch to either Treasuries or stocks (inflation rotation), or an all-in switch to either low beta defensive sectors or high beta cyclical sectors (beta rotation).  Focusing on our inflation rotation strategies for a moment, allow me to make things abundantly clear.

First and foremost, everything we do is quantitatively based on the principles of intermarket analysis.  All I do, all Ed Dempsey does, and all Charlie Bilello does is give voice to math through various writings and media appearances.  Second, the reason we called it the “inflation rotation” strategy is because when Treasuries and Utilities outperform, that should not happen when there is a feeling of reflation and increasing growth/inflation expectations.  For those that have seen me use the term “deflation pulse,” that term is meant to be a descriptor not of opinion, but price movement.  For such rotations to have power as they did in 2011 and 2012 (“The Investor with a 45% return in 2012”), Treasuries and equities need to be uncorrelated.  With the exception of the last few weeks, the correlation between the S&P 500 and Treasuries has been abnormally historically correlated this year.  Usually, Treasuries have a slight positive correlation to stocks, with that correlation turning negative during periods of high stress and volatility.  As a matter of fact, in both of our papers we show that when Treasuries and Utilities outperform, stock market volatility tends to rise.  Treasuries are THE way to play heightened market volatility.  That is precisely why we position into Treasuries when those triggers show strength.

Now, an important distinction in our triggers – they do NOT guarantee that they will be right all the time.  In the case of the top 1% of VIX spikes (a stock crash), Utilities tend to already be leading 80+% of the time before those VIX spikes occur.  However, it’s not that every time Utilities lead, you necessarily have a VIX spike.  At a recent Hartford CFA Chapter presentation, the issue of the number of false signals Utilities give when it comes to warning of stock market declines came up.  My response?  There are tons of false signals, which is PRECISELY why the indicator has predictive power for tail events.  If a signal fails 9 out of 10 times, the vast majority will say the signal is broken and abandon the discipline of a strategy that adheres to it.  Yet, the number of wrong times matters little when the magnitude of being right (the 10th time) swells any losses for being defensive in the successive number of false positives.  The reason the phenomenon exists is because the indicator is abandoned in the wait, and only rewards those who truly understand the issue of magnitude instead of frequency.

This brings us to the third point.  The enemy of leverage is volatility.  If you don’t believe me, watch leveraged exchange traded funds during periods of extreme volatility that persist.  When Utilities and Treasuries UNDERperform, our research, proven in our papers, shows that stock market volatility tends to fall.  That is exactly when you want to have equities, and have some leverage within equities.  It is for this reason in our inflation rotation strategies we not only rotate to equities from Treasuries when those areas weaken, but also leverage into it.

Now – let’s get down to the business of the last couple of weeks.  First, the last two weeks are a reminder than trading off of daily noise does not work.  Markets fell aggressively on days earlier in those weeks.  Many worried and began to sell early in those weeks, forgetting that the nature of corrections is big downs followed by big ups.  It is for this reason we ourselves use weekly triggers.  Second, a correction and period of volatility must last more than two weeks.  A real correction can last for several months.  Believing that not being exposed to Treasuries or defensive sectors in those first two weeks means the strategy has failed is simply wrong, as it depends on the behavior of leading areas of stock market volatility prior.  For us, enough strength did kick in on the triggers at the end of last week for the rotation to occur.  Whether it works or not is irrelevant in the small sample.  What matters is reading and understanding why we do what we do instead of what the trade of the moment is.

Commodities have cratered, small-caps have cratered, junk debt has cratered, worldwide government yields have cratered.  The S&P 500 has completely disregarded any of this.  No one seems to care about the absolutely enormous disconnect between equities and inflation expectations which has thrown off risk triggers.  Our separate account strategies did very well in 2011 and 2012 because historical cause and effect mattered.  Our mutual fund launched at the time when massive distortions began to take place.  The chart below is an undeniable distortion and largely explains why our own approach, as well as those of many alternative managers who have fared far worse than us and with long track records of strong performance, have been whipped around against a “beautiful” uptrend.

I believe in mean reversion.  I also believe that it is the closest guarantee one can make when it comes to market dynamics.  For the chart above to be resolved, either inflation expectations must rise and current trends are wrong (economic data and simple logic says they are not), or stocks must fall and are wrong and must have a severe decline.  Following the 1929 crash, the Dow rose in a similar way to equities in 2013 before ultimately making lower lows in 1931 and 1932.  Japan has had numerous massive rallies only to go lower.  Why?  Because deflation is horrendous, and people forget that everyone loves buy and hold at the top.

With QE ending, market volatility rising, and screaming deflationary price behavior, stocks likely need to undergo a Fall Epiphany on the realization that something is ridiculously wrong beneath the surface.  That epiphany is NOT a two week event.  If inflation expectations continue to falter like this, 1) correlations break which allow for more fruitful risk rotations, 2) risk lasts more than two weeks, and 3) higher highs become lower lows.  If QE caused the chart’s distortion above, than the end of QE should resolve it.

For us, and our inflation rotation strategies, that likely means more time on average exposed to Treasuries because of the likely outperformance in Treasuries and Utilities.  In our beta rotation approach, that means being fully exposed to Utilities, Consumer Staples, and Healthcare only within the context of a long-only equity strategy as a defensive equity vehicle.  Every single quant strategy, every single discretionary strategy, has periods of underperformance and lackluster results relative to expectations.  That period I believe is going to come to an end very soon, which implies the time to believe in historical signals, and cause and effect is now.  Our papers won awards for what we presented and we have been abundantly clear on how the strategy is executed and why.  To generate performance over time, one needs to know why it works when it works, and why it doesn’t work, so you don’t sell out at the exact wrong time.

History is a vast warning signal.  Will you buy high after highs are made, or actually buy low because future performance can look very different than the past?