Last Friday was without a doubt one of the more unnerving days of the past few months. Pretty much every indice of every asset class was taken to the woodshed for the week, which should not have been a surprise. S&P 500 -2.39%, UST 30yr -1.55%, Euronext 100 -1.42%, Nasdaq Comp -2.36%, Russell 1000 -2.41%, S&P HY Dividend Aristocrats -3.26% and even the S&P Midcap 400 was hammered, down -3.19% on the week. In fact, it was only a matter of time before it happened. US indices had not suffered a +/- 1% in 43 days! Ryan Detrick @RyanDetrick, of LPL Research posted a great piece on their blog on September 13th regarding this very topic. I recommend reading it. The VIX Index, a.k.a. Fear Index, had driven to a low not seen since July 2014, implying a heightened state of complacency in the S&P 500 Index. as represented by the lack of volatility in S&P 500 index options.
Of course, nothing lasts forever and it was only a matter of time before volatility would rear its two-faced head once again. I say two-faced because suppressed volatility gives sense of tranquility when we know it can´t last, and when it bounces we can finally get busy at allocating capital. In other words, when markets seem complacent it is best to take money of the table and when weak hands are shaken out, strong hands can put capital to work.
Such was the case last week when as we approached the close on Friday, my model suggested rotating out of TLT – iShares 20+ Year Treasury Bond ETF – and into QQQ – PowerShares QQQ Trust Series 1 ETF – effectively taking a “Risk On” stance in investment portfolios.
The purpose of today’s commentary is to admit that I had my misgivings regarding the rotation into the QQQ last week. Every month interest rate fears make headlines and financial networks whip everyone into a frenzy regarding the direction of rates. As I have stated for a long time, I believe the Federal Reserve not raise rates before elections and if the economic data does not pick up, I would not be surprised if the Fed did not raise rates in 2016 at all.
Still, my concern last week lay in the complacency of markets and the correlation among the different asset classes, which highlighted one of the weaknesses in all algorithmic models: heightened correlation between factors can be detrimental to a portfolio when they lose value at the same time, instead of balancing each other out. The key is identifying which asset will come afloat as the safe haven asset. This is done by constantly questioning your model thesis and be open to the possibility of it not working, temporarily or permanently.
Therefore, the title is apropos. It is important to stick to your guns and trust the model that you surely spent hours, days, and months tweaking, refining and back-testing. So far so good, complacent I am not!