Trends, Rates and Rotation.

(updated 11/13/20)


“Skill follows the rules, talent breaks the rules, mastery shatters the rules, but genius makes its own rules.” 
― Matshona Dhliwayo

I have been holding off on publishing this post because I wasn’t sure how the US Presidential election might affect the theory and process behind my primary model, “Risk On or Risk Off” or here forth to be known as “RORO”. History proves that it shouldn’t affect much, in spite of the existing unique pressures to erode the US Dollar hegemony. In fact, the S&P’s best returns historically have been when the White House was occupied by a Democrat. Don’t forget, Obama probably benefitted from the economy bouncing back from the Great Financial Crisis and Biden will likely continue to benefit from the massive stimulus being injected to combat the effects of the COVID-19 epidemic.

Over time, money and investment flows are important impulses to economies and markets. I fully believe that USD relative hegemony isn’t likely to change in my lifetime. The desire of many countries to seek more access to China will invariably result in less than desirable domestic development, which could well reinforce the need to maintain a strong relationship with the US. After all, China is a one-party authoritarian regime, which has proven over time to care little for the democratic or healthy economic development of their trading partners. The best and most recent example of this is Venezuela. Countries and leaders see this and nationalist impulses usually kick in at some point in the relationship. Perfect recent examples include 5G network build outs in EU and resistance to Chinese appropriation of sandy banks in the South China Sea.

According to data from the Bank of International Settlements, dollar credit growth remains robust outside the US, whereas the trend in Euro credit continues a weakening trend.

If we want to understand demand for USD in emerging markets, it is clear that each crisis leads to increased need for funding, preferably in the most liquid and stable currency available. The need or want for dollars remains an important part of global liquidity and shedding dollars tends to be a brief occurrence before picking back up again.

*BIS, USD Credit to Emerging Markets and Developing Countries

The cost of this funding remains relatively cheap, compared to past global shocks, as evidenced by Emerging Market OAS.

In addition, US High Yield OAS is displaying the same relative resiliency. This is due in large part to Federal Reserve purchases of corporate debt as an emergency backstop to the stress felt in debt markets.

It is important to note that since the 3rd quarter of 2019, there have been 2 major shocks to the US Treasury market, known today as the “Repo Madness” and the “Cash-Futures Basis Blowup”. Both cases highlight how sudden spikes in yields can have a devastating effect on financial institutions and how important it is to maintain liquidity in that market. Jerome Powell recently alluded to as much and it supports the notion that the FED is willing to put a cap on yields to avoid sudden shocks to liquidity.

So, there are some trends that require reviewing. First of these are M2 Money Stock and the Velocity of Money. As of October 26th, there is over $18.8 trillion of money supposedly “sloshing” around in the economy, yet it isn’t sloshing. It is sitting like stagnant water and proving that deficits are deflationary.

*CPI for All Urban Consumers (CPI-U), US Bureau of Labor Statistics
*Visual Capitalist

That said, US GDP continued to expand pre-COVID. Employment was at all time highs and lost 25.4 million jobs in the shutdown. As the economy comes back to life, employment is only 6% from the highs. With added stimulus, this trend should continue. The key is not have more lockdowns and people should be proactive in protecting themselves from further exposure. Needless to say, a vaccine can’t come soon enough.

*Employment Level, US Bureau of Labor Statistics

That said, a Biden presidency (still to be confirmed) will have to deal with a Republican-controlled Senate and a strengthening Republican block in the Democrat-controlled House. Prior to the elections, Trump had reportedly signed off on a new $1.8 trillion stimulus package, while Nancy Pelosi had pushed a $2.2 trillion “Heroes Act”. Posturing led to suspension in the negotiations and it stands to reason that Mitch McConnell now has even more leverage than before to negotiate a number less than $2 trillion. Again, deficits are deflationary and policy makers have to decide where to draw the line. Again, if a vaccine is made available in the first quarter of 2021, less stimulus will be needed.

Since the mid-1990’s neither party has had dominant control of either the House or Senate. A wise acquaintance of mine, Col. John Fenzel, said it best recently:

Given this scenario, it begs the question of whether or not a divided government could have an effect on stock markets. In fact, in spite of the bursting of the tech bubble, Great Financial Crisis and COVID pandemic, the S&P 500 is up a cumulative 138.86% since January of 2000. History suggests that staying out of the market at any time would have been detrimental to longer term savings. A divided government likely does little to disrupt the status quo.

*Haver Analytics, Invesco 2020 US Presidential Election

So, this brings us to the topic of the direction of interest rates. With the government determined to rescue the economy, it will be required to maintain a low interest rate environment for the foreseeable future. I will go so far as to say that it is foolish to entertain significant rate hikes, even after a vaccine/treatment is widely available. The Federal Reserve can simply begin to reduce the size of its balance sheet, selling assets back to the market, which would invariably allow some slippage in yields and further steepening of the yield curve without shocking the short end.

As I write this, US 10-year rates are at 0.966% and rising. The recent closing low is 0.536% set on July 27th. A rising 10-yr is great for banks and the economy in general, but coupled with improving employment trends, a solid housing market, low inflation and continued support from Congress and the Fed, it remains a strong tail wind for the economy.

Of course, the unwind of the balance sheet would probably have to be low and slow. The last time it was attempted, it led to the liquidity seizure in big banks in 2019. It becomes quite clear that for the past 20 years, the US has been rolling through brief rate cycles that end up going lower for longer than in previous decades, though the trend remains down. This trend or suppression of perception of risk and cost of money supports the idea that US Treasuries will remain a safe and relatively risk free asset for investors. I do not subscribe to simply holding them, but using them as a tool for reducing risk or exposure to other assets in times of stress. As we see more inflationary trends, it is useful to consider US Treasury Inflation Protected Securities, or iShares TIPS Bond ETF (TIP), as an expression of “Risk Off”. I have yet to model this in the base RORO strategy.

The thesis for the model also depends on the US Dollar remaining the world’s reserve currency and not falling into a vicious political cycle where it truly becomes a “banana republic”. As long as the US economy remains a potent military, technological and economic power, the need for dollars will remain. Better yet, the US remains one of the most effective democracies, es evidenced by the balance and separation of powers that stands true today. Any thought to the contrary is simply and overly affected by too much propaganda via social media.

This brings me to the issue of the validity of the model I use to provide alpha to investors that choose to use RORO (“Risk On or Risk Off”) as a tool for market participation. I have yet to find an indice with robust liquidity that provides growth superior to that of the Nasdaq 100. Yes, the top 5 or 6 largest stocks are driving performance, but you might be surprised to see that the top 10 performers over the past 3 years include others:

*Top 10 3-yr Performers, Investing.com

My simplistic view of this index is that the composition of the index is more organic than the Dow Industrials and S&P 500. Tesla was denied entry into the S&P 500 for what I think are valid reasons, but if we base our decisions on subjective opinions we run the risk of underperformance. Leadership in this indice rotates over time and it includes companies from all sectors of the economy.

The database used in this model goes back to October of 1985 when the Nasdaq 100 (NDX) first traded and effectively begins on November 1st of that year. The NDX has grown +10,299% since then (as of November 6), compared to the S&P 500’s (SPX) +1,732.41%. If SPX is the standard by which money managers measure relative performance, why not aspire to provide alpha by using a different indice as an indicator?

So, the index-based model has yielded a total of +6,482.74% and is up 28.12% YTD with a 0.27 Sortino Ratio. It is important to remember that ETF’s that are modeled on a particular indice will often perform slightly differently. The result of the model with ETF’s reflects this, up 44.85% on the year, compared to the SPY’s +10.65% (updated 11/13/20). This is alpha creation.

Recent conversations with acquaintances led me to do a study of returns incorporating energy stocks into the model. This arose out of their suggestion that the economy was trending strongly before COVID and commodities should play a larger role in portfolio construction in the next couple of years. I have long considered Gold as a “Risk Off” tool in a related strategy, but had never given Oil consideration, due to the volatility and long bust cycles that tend to occur.

So, the three tradable models have one thing in common. They use the Nasdaq 100 or Invesco QQQ Trust (QQQ) as an expression of “Risk On” and US 30yr Treasury or iShares 20+ Year Treasury Bond ETF (TLT) as a “Risk Off” tool. In the RORO w/Gold model, the SPDR Gold Shares (GLD) ETF is used with TLT as a 50/50 allocation in “Risk Off”. The RORO w/Gold & XOM uses the Energy Select Sector SPDR Fund (XLE) ETF with TLT & GLD as a 50/25/25 allocation in “Risk Off”.

It is important to backtest models, even though the past isn’t predictive of future results. These are the annual results using the indices and Gold futures prices:

Remember, I am loathe to use XLE in the “Risk On” portion in the model because it, or Exxon Mobil (XOM) as a proxy for longer time frames, has NEVER consistently outperformed QQQ and in most years has been a drag on performance. Since 1985, XOM has yielded an annualized +4.53% return (not including dividends), whereas the Nasdaq 100 has yielded +14.17%. These are the annual results, using the indices, Gold futures prices and XOM as a proxy for oil stocks:

In spite of the historical benefits of incorporating more inflation-sensitive assets such as gold and oil, the RORO base model (QQQ & TLT, only) still provides better long term return for those less inclined to make decisions on more cyclical assets.

Again, backtesting with as much history as possible is essential for detecting and analyzing specific scenarios that may have affected the model and may arise again. This is the same RORO base model using the NDX and 30-yr US Treasury bond since 1985:

By no means do I suggest that this is the best way to invest for the long term. I have no doubts that there are many traders and systems that provide great performance for investors. That said, even the best run into difficulties. Jim Simons’ Renaissance Technologies reportedly dropped 21% as of June 2020 in a market neutral strategy. The RORO model this year had its worst weekly drawdown on March 13th, yet was able to remain +6.39%. The reason is simply because it rotated from 100% QQQ to 100% TLT on February 21st and remained there until the 10th of April, capturing an additional +7.98% in value.

If you have a view regarding the direction of oil and gold for the next 5 years, that’s great. The historical returns for these assets are posted above and you are more than welcome to contact me to discuss the methodology and how my process may complement your own.

*Disclaimer: Past performance is not predictive of future performance. Please seek advice from an investing professional before putting any of your money in the market. The contents of this site and blog are property of Carlos Ledezma and reflect his own work and opinions and will not assume any responsibility for how his work is interpreted by others. The returns presented are based on closing prices only and do not include dividends paid to potential holders of the assets.


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