Ignoring the Noise

Since beginning the Absolute Return Strategy, every year has posed a number of risks to the viability of the model.  The main risk is the possible correlation of different asset classes within a single market, since the assets I am using for this model are the QQQ and TLT exchange traded funds, which focus on the US.  Say what you will about highly concentrated strategies,  many investors, US and international, prefer the use of exchange traded funds (ETF’s) for asset allocation to sectors or industries.  Fortunately, the daily volume in both ETF’s is enough for most small and medium-sized investors to use them as recommended by this model.  Much like the moving average signals described by Steve and Holly Burns in their book, “5 Moving Average Signals THAT BEAT BUY AND HOLD” , my model tells me when to go long stocks and when to seek shelter, especially if I need to make the most of my limited resources available for investment.

As mentioned in previous posts, my biggest peeve with markets is that there is too much noise and not enough simplicity.  Too much diversification also leads to underperformance, because not all boats are able to float with the same wave.  Some boats have holes in them and when the keel is not touching sand, the boat takes on water.  The S&P 500 has gained 5.81% annually (in price only) since May 19, 2006 (the start date of this model) and the FTSE All World Index has gained 3.10% annually.  My analysis identified the Nasdaq 100 as the best index to use as an expression of “Risk On” and when things get tough the long-dated US Treasury bonds have provided the best shelter for risk aversion.

The past few years have not been kind to some macro investors.  Crispin Odey lost close to 50% in 2016 and John Burbank III is shutting down his long-short equity fund, after losing a reported -11.77% last year and -2.09% through February.  Common themes among top macro managers has been their bearishness on China, the over extended valuations in equities and credit bubbles that have appeared in several markets.  Many thought Chinese credit bubbles would burst and expected China to devalue their currency much further and begin a currency war.  Thankfully, those extremes have yet to be seen, though many asset managers have been hurt for that almost apocalyptic view.

On the other hand, Kyle Bass did quite well in 2016, the Hayman Capital Master Fund returned 24.8%, after being down by 10% in the first half of the year.  The recovery was due in large part to his timing of the bond market rout in Q4 of 2016 and currencies.

Those who read “The Big Short” will remember that Michael Burry was one of the first to call the subprime mortgage crisis and had to survive an investor revolt before reaping the rewards.  John Paulson reportedly jumped on the trade a year later and also did extremely well.  The timing of a narrative may not always be spot on and fighting the trend can be very costly.  Many cautious money managers missed the Trump “reflation” trade and are surely paying the price with fund redemptions.  My point is that one should not hold blindly to a narrative when the market is doing something else and it is useful to have a time-tested, or back-tested, indicator.

My base model is up 11.08% year to date.  Last year, it closed up a measly +2.29%, having taken a beating after the elections.  If you remember, equities and bonds were highly correlated for a short period of time, long enough to force the strategy to lose -8.97% in the fourth quarter.  Since then, the base model has recovered quite nicely, remaining in QQQ for 11 of the past 16 weeks.

Absolute Return 210417.png

Going forward, I suspect that the model may flip-flop a couple more times this year, while the US equity market looks for a wall to crash into.  Sometimes, this evolves into a “wall of worry”, though I must admit that I keep tabs on the elevated market valuations and it is possible that a single global event could trigger a correction.  According to FactSet, the trailing 12-month P/E for S&P 500 companies is 21.9, above the 10-year average of 16.6 and the highest it has been since the financial crisis.

Factset PE

My view has always been that it is an error to focus solely on the P of P/E.  First quarter S&P 500 earning are coming in at a 12.5% YoY growth rate, the highest since 2011 (as per FactSet).

Factset earnings growthIf the E of P/E keeps rising, the P/E ratio will not appear as bubbly as many expect.  I will be looking forward to seeing the NFIB survey results in May for more color on business expectations.

Among the risks to the US recovery, Donald J. Trump remains one of the more serious. The President of the United States failed in his first attack on the Obama legacy, which was repeal and replace Affordable Care Act (ACA), also known as Obamacare. Many small and mid-sized businesses were looking forward to a less expensive healthcare system.  The next NFIB survey will provide insight to their reaction.  DJT also promised to lower taxes and it is highly unlikely he will get a broad tax cut.  Also, lest we forget, the wall isn’t happening…yet.  The swings and misses are beginning to add up and an ineffective president is, as DJT himself would say, BAD.  Inciting a nuclear war with North Korea would also be very, you know, BAD.

Regarding the twin elefants in the economy, I cannot help but refer to the research provided by Danielle DiMartino Booth (@DiMartinoBooth).  As a former Fed insider and author of best-selling book, “FED UP“, she has used her experience to become one of the foremost experts on credit and rate markets.  Since founding “Money Strong, she has harped on growing pension shortfalls and growing credit bubbles.  According to research published by Morgan Stanley at the end of March, deep subprime auto-loans are now 32.5% of subprime, up from 5.1% in 2010, therefore loan securitizations are becoming much riskier and companies are increasing loan loss provisions, pushing many into the red.  After analyzing the payment behavior of subprime borrowers, analysts at S&P say that today’s subprime borrower is weaker than in previous years.

Only adding salt to the wound is the $1.3 trillion pension deficit.  According Danielle’s work, average state pension funds returned around 1% last year, compared to the needed 8%.  If one were to reinvest the 3% interest from 30-yr Treasury, it becomes readily apparent that it is still extremely difficult to make up the 5% gap.

For more color, The PEW Charitable Trusts published a report on April 20th regarding The State Pension Funding Gap: 2015.  As of the end of 2015, the funded ratio of state pension funds was 72% and the last time pensions were fully funded was 2001.  This means that investment returns have not been enough meet future liabilities.

PSRS_The_State_Pension_Funding_Gap_2015_Figure1

If the gap between the two lines does not narrow, a bailout will be needed somewhere along the line.  If the Federal government provides support, partial or total, this will  increase total Federal Assets, at a time when the Federal Reserve is contemplating strategies to raise interest rates and reduce its balance sheet.

fredgraph

Forgive me for being skeptical, it is borne out of seeing politicians muck it up consistently for a number of years.  The issues facing politicians and economists are too big for their shorts and the can keeps getting kicked down the road.  I hope corporate earnings continue to grow, but I fear for the policy errors that the Fed and POTUS are capable of delivering to the US.  Thankfully, I have a model that allows me to ignore all that noise.


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