An Intermarket Approach to Beta Rotation

An Intermarket Approach to Beta Rotation The Strategy, Signal, and Power of Utilities Market Technicians Association An Intermarket Approach to Beta Rotation Charles V. Bilello, CMT Michael A. Gayed, CFA Twitter: @pensionpartners

Pension Partners, LLC About Us Investment manager of mutual funds and separate accounts Absolute return and equity sector rotation strategies Quantitative, objective investment process utilizing the principles of Intermarket Analysis For more information, contact us at solutions@pensionpartners.com Market Technicians Association An Intermarket Approach to Beta Rotation

Introduction The Active Trader s Problem Buy and Hold the ultimate investment strategy Efficient Market Hypothesis (EMH) active traders can t consistently outperform Investment managers unable to beat benchmarks Stock picker s market at odds with empirical research on passive asset allocation The problem is

Introduction The Active Trader s Solution Numerous studies put into question EMH Inefficient Markets Momentum Volatility Clustering Gradual Diffusion of Information Seasonality If markets are not fully efficient, active traders can take advantage of anomalies Market Technicians Association An Intermarket Approach to Beta Rotation How?

Introduction DEFINING Intermarket Analysis Branch of technical analysis Study of asset class and sector relationships within on- and Relative movement across and markets can be predictive of coming booms, busts, volatility, economic changes Ways of using intermarket analysis? Market Technicians Association An Intermarket Approach to Beta Rotation

Why We re Here 2014 Dow Award Winning Paper

Our Agenda What We Will Be Covering Today Part I: History and Literature Review Technicians recognizing Utilities Momentum, and seasonality Drivers of leadership Part II: The Strategy Price versus total return Methodology Backtested results Part III: The Signal Leading indicator of volatility Sell in May, Rotate Away? Part IV: Implementation/Strategy in Action Conclusion

History & Literature Technicians recognizing Utilities John Murphy noted behavior prior to a stock market top Martin Pring observed performance of Utilities at major lows One of the best early predictors of the stock market (Edson Gould) The Utilities reflect to a greater extent than the Industrials the investment demand for stock. Combine these observations with Market Technicians Association An Intermarket Approach to Beta Rotation

History & Literature Momentum and seasonality Persistence of sector strength in shorter time periods (Moskowitz and Grinblatt) Weekly portfolio returns are strongly positively autocorrelated (Lo and MacKinlay) Combination of momentum and short time periods has implications on seasonality Utilities sector uniquely not impacted by worst 6 month period for equities (Jacobsen and Visaltanachoti) Combine these observations with Market Technicians Association An Intermarket Approach to Beta Rotation

History & Literature Drivers of leadership Most bond-like sector of the stock market Industry will lead market if it contains important information about fundamentals (Hong, Torous, and Valkanov) Less cyclical nature of Utilities due to prior regulation Ultimate driver of performance is expected cost of capital and future interest rates If bonds are leading indicator of economy, Utilities are leading indicator of stock market

The Strategy Price versus total return Most technicians focused on price only through Dow Utilities relative to Industrials Problem? Not cap-weighted, not total return Dow Industrials value in 1998 would be 652,230 with dividends reinvested versus price only level of 9,181 (Clarke and Statman) Solution? Use Fama-French data which is market weighted and total return going back to 1926

The Strategy Methodology When a price ratio (or the relative strength) of the Utilities sector to the broad market is positive over the prior 4-week period, position into Utilities for the following week. When a price ratio (or the relative strength) of the Utilities sector to the broad market is negative over the prior 4-week period, position into the broad market for the following week. Converting monthly to 4 week intervals allows for more tactical trading Beta Rotation Strategy (BRS) historically has significant performance

The Strategy Backtested results

The Strategy Backtested results Outperformance consistent around major legislative events for Utilities

The Strategy Backtested results Outperformance consistent by decade

The Strategy Backtested results BRS outperforms the market in 82% of rolling 3- year periods

The Strategy Backtested results BRS exhibits superior risk-adjusted returns

The Strategy Backtested results Long/short variation produced consistently positive annualized returns

The Signal Leading indicator of volatility Impossible to historically implement BRS before advent of Exchange Traded Funds (ETFs) However, Utilities is about more than just strategy The lead-lag behavior of the Utilities sector can be a critical warning sign of higher average volatility to come in the market, and can be an early tell of whether the odds of an extreme tail event are rising.

The Signal Leading indicator of volatility Volatility of the market when Utilities lead is higher than when they lag

The Signal Leading indicator of volatility Utilities leadership tends to precede worst market declines

The Signal Leading indicator of volatility VIX spikes often occur when Utilities already outperforming

The Signal Sell in May, Rotate Away? Sell in May, Go Away instructs investors to sell stock holdings in May until worst 6 month period has passed Persistence of strategy occurs globally, potentially due to vacations, changes in risk aversion due to SAD, etc. Utilities show least differential among sectors between summer and winter months (Jacobsen and Visaltanachoti)

The Signal Sell in May, Rotate Away? BRS more often in Utilities during Summer than during Winter months

The Signal Sell in May, Rotate Away? Leadership may be due to Treasury yields falling during Summer months

The Signal Sell in May, Rotate Away? BRS outperforms simple switching of Utilities or market based on Sell in May

Implementation Exchange-Traded Fund Strategy Advent of ETFs, combined with lower trading costs, allows for BRS replication Closest to Fama-French data are Utilities Select Sectors SPDR Fund (XLU) and Vanguard Total Stock Market ETF (VTI)

Strategy in Action 2010: Flash Crash

Strategy in Action 2011: Summer Crash

Strategy in Action 2012: 2 nd Quarter Correction

Strategy in Action 2013: Ignored Signal/Persistent Strength Market Technicians Association An Intermarket Approach to Beta Rotation

Strategy in Action 2014: No Large-Cap Correction But

Strategy in Action 2014: Small-Cap Correction

Conclusion Predictive power Signaling power of Utilities is a market anomaly that has persisted over time Why? Fluctuations in relative price movement has important information on interest rates, macro factors, and sentiment Simple rotation between Utilities and Market significantly outperforms both Leadership can provide traders with clues on the potential for higher volatility and extreme market moves ahead of time

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