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Conditions vs. Predictions

The S&P 500 continues to hit new all-time highs. This is bullish, we are told, as new highs are typically followed by more new highs. True indeed, at least until the last new high is reached; that last new high or “the” top is unquestionably bearish. The hard part, of course, is in sorting out the many minor tops from “the” top. Many have tried and failed over the past few years and after the unrelenting advance in 2013, nearly all of the prominent Bears have capitulated.

Rather than trying to predict “the” top, our process involves a continual assessment of underlying conditions, attempting to answer the following question: are conditions currently supporting an expansionary or a contractionary environment? In answering this question, we are not seeking certainty as there is no such thing as certainty in trading or investing. Instead, we are merely evaluating the probability of various outcomes. While that’s not nearly as exciting as making a bold prediction, this is the best you can do in this business; anyone who tells you otherwise is being disingenuous.

Through our years of research we have found that the probability of weakness within the equity market is higher when certain contractionary conditions are prevailing. In our absolute return vehicles, when these conditions are present, we rotate fully into bonds, taking on a more defensive posture. On average, bonds tend to outperform stocks during such periods. We saw this most recently during the 6% correction from mid-January through early February. Our process identified contractionary conditions in advance of this correction and we were able to protect capital by rotating into bonds.

Now, does this mean that every time we rotate into bonds we are predicting a top or “the” top? Absolutely not. It merely indicates that risk in the equity market is rising and that the prudent trade over a full market cycle is to rotate into bonds when such contractionary conditions are present. For certain, there will be times when our signal to rotate into bonds is wrong and equities continue to advance. But just because you got home safe after drinking and driving, it doesn’t mean it was a good idea. In the same way, just because stocks may have continued to advance while underlying conditions suggested caution was warranted, it doesn’t mean that it was a good idea to remain leveraged long to the equity market.

Similar to January, we recently rotated back into bonds as our models were pointing to a contractionary environment. Strength in defensive sectors such as Utilities is one such concern here. As you can see in the chart below, the relative strength in Utilities has remained strong in the face of new highs in the S&P 500. This defensive behavior is not typically seen in an expansionary environment.

XLU

It remains to be seen if this defensive posture is short-lived, plays out similar to January, or develops into something more concerning. From our standpoint, though, there is no value added in making such a prediction. We need to be open to all three scenarios. As such, we will continue our assessment of underlying conditions, and are prepared to react when conditions change.

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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