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An Intermarket Approach to Tactical Risk Rotation

We are honored to announce that the National Association of Active Investment Managers (NAAIM) has awarded us 3rd place in the 2014 Wagner Award competition for our paper entitled “An Intermarket Approach to Tactical Risk Rotation.” The full paper is now available to download on the Social Science Research Network (SSRN) (click here).

In the paper, we reveal a Tactical Risk Rotation Strategy (TRRS) that uses the relative strength of long duration Treasuries (30-Year) to intermediate-term Treasuries (10-Year) as an indicator to rotate fully into either equities or bonds. Such a strategy would have achieved outperformance on an absolute and risk-adjusted basis since 1977. More importantly, though, we illustrate that when long duration Treasuries are outperforming, it can serve as a warning sign of increased volatility and a higher probability of a market correction in the short-term.

Understanding that most advisors are not comfortable executing an all-in strategy for clients, we also outlined an approach for asset allocators to shift their mix of equities and bonds based on the same signal. We showed that using such an approach would have produced superior risk-adjusted returns as compared to a more traditional rebalancing strategy.

We also illustrate a modern-day implementation of the strategy using Exchange-Traded Funds (ETFs). The two ETFs that most closely approximate the 30-year Treasury and 10-Year Treasury were the iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the iShares Barclays 7-10 Year Treasury Bond Fund (IEF).

What are these ETFs telling us currently?

In the top panel of the chart below, we illustrate a monthly ratio of intermediate-term bonds (IEF) to long duration bonds (TLT). As you can see, the ratio has been declining for the entire year thus far. In our paper, we show that this behavior tends to proceed periods of higher volatility in the equity market. Indeed, as you can see in the bottom panel of the chart, in the past few years whenever we have witnessed a persistent decline in this ratio there has been a sizable correction in the S&P 500. Thus far in 2014, the cap-weighted S&P 500 has ignored the outperformance of long duration Treasuries but the average stock is telling a different story. The Russell 2000 is down close to 11% from its early March peak and down -5.8% on the year.

TRRS1

It remains to be seen if the S&P 500 syncs down to the Russell 2000 with a decline or if the ratio begins to improve with intermediate-term Treasuries starting to outperform. In the near-term, the wide and persistent gap in performance between long duration and intermediate-term Treasuries is at the very least cautionary and as long as it persists we can say there is an above-average risk of higher volatility to come. It is additionally concerning given the strength in the Utilities sector which also tends to precede periods of higher volatility, a concept we wrote about in a separate paper (click here) which received the 2014 Dow Award from the Market Technicians Association.

We hope that you enjoy reading the paper and learning more about the signaling power of Treasuries. The behavior of Treasuries is one component of our ATAC rotation strategies used to manage mutual funds and separate accounts. We look forward to providing further insight into our quantitative investment process in the coming months.

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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