“It’s in literature that true life can be found. It’s under the mask of fiction that you can tell the truth.” – Gao Xingjian
Sometimes, all you need is the turn of the calendar for stock market dynamics to dramatically change. Anyone vaguely aware of market movement this past week is seeing this first hand. On the final trading day of 2014, the VIX (NYSEARCA:VXX) index experienced it’s largest one day percentage advance in history, with seemingly no one noticing. Out of the gate entering 2015, risk assets worldwide suffered heavy declines, followed by strong advances on Fed minutes, and ending with another large breakdown. Importantly, the relationship of risk assets like the S&P 500 (NYSEARCA:SPY) to Treasuries and defensive sectors began aggressively reverting to historical behavior. Suddenly, the distortions and disconnects of the last year and a half seem to suddenly be going away.
This has been a week of Greek mythology for both the Phoenix and Cassandra. The mythical bird known as the Phoenix regenerates from his predecessors, arising from the ashes to be born again. The story of the Phoenix relates directly to investor complacency which kills the bird, and volatility which returns afterwards. Indeed with Quantitative Easing over, and undeniable proof that deflationary pressures are only increasing worldwide, the volatility phoenix is burning it’s fire at the start of the year.
Yet, because of small sample bias, the availability heuristic, and representativeness, investors wrongly think the environment for stocks of the past year and a half has been normal. It simply has not when looking at quantitative models that analyze large cycles. The unrelenting decline in long duration government bond yields is a direct spit in the face of central banks who continuously use words to assure the markets that their stimulus is boosting inflation at economic growth. People seem to think that what we have been pointing out regarding interest rate movement means we are “perma-bears,” completely failing to understand the historical relationships of bonds to stocks, and forgetting how bullish our approach turned us in late 2011 and 2012.
What is crucial here is not just the return of volatility, but also the return of defensive relationships serving the role of defense as opposed to offense. Last year, Utilities and Treasuries did extraordinarily well. However, they tend to do that during periods of high risk and difficulty for buy and hold. Instead of being a way to bypass periods of heightened stress for overall beta, they became the hottest momentum plays, while large caps ignored widening credit spreads, collapsing commodities, and falling inflation expectations. People seem to forget just how defensive assets perform when you have a true “risk off period.” Put simply, the magnitude of outperformance being positioned in Treasuries and defensive equity sectors (as our inflation and beta rotation strategies do respectively) can be immense in a short period of time. I encourage those truly interested in proof of this to view the recorded presentation I’ve been doing around the country, available by clicking here.
This has been a prolonged period where correlations have been out of whack, false positives have persisted, and risk has not mattered. Logic dictates then that strategies which rely heavily on managing risk pre, not post, through proven leading indicators of volatility can suddenly stand out in an asset allocation mix. If conditions have changed, so too then has the backdrop of an approach based on intermarket analysis and active rotations.
Treasuries are the modern day version of Cassandra, who in Greek mythology had the gift of seeing the future, and the curse that no one ever believed her (click here). No class of investors has been more wrong than those calling for a rising rate environment. While the Fed focuses on the patience of when to raise rates, long duration Treasuries are the most patient of all, waiting for the moment where stocks respect their message beyond headlines of weak wage growth and falling Oil. The time now for the notion that falling rates are good for stocks is the next narrative to be proven fictional given that interest rates are a reflection of the demand for money. This is not commentary about stocks or bonds going up and down, but rather an argument for risk to matter.
Your ability to stick to a strategy matters more than the strategy itself. Will you stick to buy and hold if we re-enter an age of turbulence?
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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