Relative Strength Update... Easy Money Edition

Below is an update of a relative strength chart I presented last August, a point which turned out to be right near the bottom of the summer's equity sell-off. At the time I noted that the chart:

Puts the dollar sell-off (commodities and gold are ripping) and risk-off (financials are sliding, Treasuries are rocking) in perspective.

This time around we've seen a remarkable recovery in risk assets, especially REITs (from 4th to the bottom to the top) and Financials (from the bottom to 4th from the top). Note also the continued strength in long treasuries (remaining third strongest).

The reason of course has been the Fed's easy money / quantitative easing that has pushed up asset values despite a lackluster recovery (especially helpful for bank balance sheets). Interesting to note that despite the response (or perhaps because of), the two weakest asset classes above are the Euro and EM currencies, showing that perhaps the massive response was not only helpful, but (a case can be made) required given the slowing economy and gridlock on the fiscal side in Washington.

Year to date the strong performance outlined above is even more clear, as can be seen below. Basically, if you haven't made money in 2012 you're doing something wrong. All of the asset classes are up with the exception of Treasuries (and up by a lot, with minimal volatility, and with hardly a draw down across asset classes).

Hopefully six months from now I won't be posting an update outlining that this marked a near top.

Source: Yahoo Finance

Relative Strength

I present below the "EconomPic Data Relative Strength Index".

What it shows is the percent that a variety of ETFs are above and below their 52 week lows and highs, as well as the relative strength (i.e. combination of the two - i.e. if an ETF is currently 20% below its high, but 30% above its low, then the relative strength is 10).

Puts the dollar sell-off (commodities and gold are ripping) and risk-off (financials are sliding, Treasuries are rocking) in perspective.

Source: Yahoo Finance

QE2 is Coming

QE as in quantitative easing. The "money" sentence from the FOMC statement:

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

Not a surprise that Treasuries (including TIPS) rallied along with gold and the Euro, but interesting that commodities (including oil), REITs, and financials sold off post-announcement. Perhaps a sign that QE is a sign of desperation and desperation isn't good a good sign for global demand.



Source: Yahoo

Long Fixed Income. Short Almost Anything Else

I think it's fair to classify today's market performance as simply a reversal of Monday (the one exception being gold).



It may be worth while keeping an eye out for that shiny metal...

Source: Yahoo

Risk Assets vs. Money Market Flows...

I must say the below chart is interesting, but as we all know "correlation does not imply causation"...



So did the fear that caused the sell-off in risk assets ALSO cause the flight to money markets (and the subsequent ease of fear that caused the reversal to occur) OR did the flows from money markets itself cause the rally?

Source: BarCap / ICI

Quality Spread Rotation...

Earlier this week EconomPic took a look at the relative returns of high yield vs. investment grade corporate bonds given the spread between the yield levels of the two. In a nutshell, when spreads between high yield and investment grade are 600+ bps, high yield has significantly outperformed. Otherwise, performance has been mixed (see chart).

Below, equities are thrown into the mix. The chart uses the same x-axis as yesterday's analysis (the spread between high yield and investment grade corporate bonds), while the y-axis shows one year forward excess return of both the S&P 500 (including dividend reinvestment) and high yield.



Unlike the strong correlation between changes in high yield spread and the performance of the S&P 500 that we've seen in the past, the performance of each is very different when spreads are low or when spreads are high*.

Which leads to the next chart detailing returns of investment grade, high yield, and the S&P 500 using the same "spread" metric, but showing the average annual performance of each in absolute terms across three "spread buckets" since 1994.



Now the fun begins.... assigning a 'best performer' to each bucket (S&P 500 when spreads are narrow, investment grade credit when spreads are "mid", and high yield when spreads are wide) and allocating monthly to the 'best performer' based upon the month-end spread differential between high yield and investment grade, we get the 'rotation' returns generated below.



While investment grade, high yield, and equities (i.e. the S&P 500) have all provided remarkably similar returns since 1994 (which is as far back as I was able to pull high yield spread data), the 'rotation' returns have significantly outperformed, up more than 11% per year with a similar level of volatility (compared to 7.3% annualized returns for the S&P 500 with more than 15% volatility).

It will be interesting to re-run the analysis as I dig up high yield data going back further, but in the meantime we need an official name for this type of rotation as "Quality Spread Rotation" isn't cutting it.

Any ideas?


Source: Barclays Capital


* Low:

When spreads between high yield and investment grade are low it likely:

• Means that more investors are risk seeking on the margin
• Reflects a decent economic environment
• Equates to cheap fixed income financing for corporations (low spreads on borrowing costs)

All of which feed into higher earnings (all else equal) and earnings flow through to equity investors. Throw in the potential P/E multiple expansion when spreads are tighter and you get a great environment for equities.

High:

When spreads are high, those higher coupon payments are made to the high yield investor and everything detailed above is reversed. At the same time, high yield investors have a more secure spot in the capital structure than owners of equity, thus first rights to a corporation's assets if there are defaults (i.e. they have recovery value, whereas equity investors do not).

Investing with a Steep Yield Curve

World Beta with some great analysis on how a variety of asset classes have historically performed given the steepness of the 3 month to 10 year points in the yield curve in his post Investing Based on the Yield Curve – REITs Like it Steep.

Here is the data in chart form separating returns into times when the yield curve was relatively flat (less than 1%), moderate (1-2%), or steep (more than 2%)....



Surprising (to me) is not the outperformance of REITs during periods in which the yield curve is steep (steep yield curves are good for banks, which means in normal times they are more willing to lend [this time may be different warning]), but the STRONG underperformance of commodities and gold during these times (I figure most of the times that the yield curve was steep over this period was during downturns when the Fed was adding liquidity or in other words disinflationary periods, which aren't good for commodities).

Where to Hide?

Any concerns within broader credit markets need to start with sovereign risk (per The Star).

The sovereign debt crisis contagion is spreading in Southern Europe, from Greece to Portugal, Spain and Italy, where government debts and budget deficits are high.

Investors have sold government bonds in those countries as perceived default risks have risen.

This has resulted in the rise in the yields of government bonds resulting in higher borrowing costs for the government and private sector as loans are often tied to the risk free rate of government bonds.

But that is not where it ends.

Since the remarkable comeback across all risk sectors following 2008's collapse (the illiquidity in TIPS during the crisis made them trade among credit risk sectors), corporate bonds (both investment grade and high yield), agency mortgages, and even TIPS have been under pressure.



So if you can't hide in credit, TIPS, or mortgages, where can you hide and get more than 0%?

I have a few ideas, but would love everyone's thoughts...

Source: BarCap

Market Recap (2/08/10)

As long as markets remain as interesting (volatile) as they've been, I'll occasionally be posting these daily updates.

The story of the day? Long fixed income, short risk assets.



Source: Yahoo

Asset Class Performance: It's Been All E.M.

Jeremy Grantham details asset class performance over the past decade in his latest missive What a Decade (bold mine):

The efficient market people, who apparently will take their faith with them to the grave, will say we were lucky (GMO closely predicted the order of the below asset class returns), in spite of the one in several hundred thousand odds of being correct. “Preposterous. How can the risky asset underperform cash for 10 years?” you can hear them say. But we would say it was just the normal grinding of regression to the mean. It’s an awfully normal world we inhabit, in the long term. It’s only the short-term zigs and zags that drive us all crazy, and right now we should brace ourselves for some very odd and unpredictable short-term market effects brought on by the recent crisis and the massive governmental response. But the bigger danger is that once again the Fed is playing with fire!

Source: GMO

An Equity Correction?

Equity futures are pointing up this morning and chatter is that this is the end of the "correction". While I personally do believe a broader correction in the equity market is likely given current valuations (in my opinion 'technicals' remain strong and 'fundamentals' are okay), a market that is down 2% over a three week time frame is NOT a correction.



Yes, in the (brief) year that is 2010, asset class returns have thus far favored anything "fixed income", but after a 60%+ run up in equities (from March '09 lows), I am not sure how this 2% downturn can be considered anything, but noise.

2009 Performance Snap Shot

I think this is the chart that speaks 1000 words. To try to summarize all of it in one sentence... all ships rose with the rising tide.



Why?

Well, what was the alternative option for an investor than to dip their toe in the water? A 0.2% return on cash.

Source: Capital Spectator

En-Down-Ments

NY Times details:

Steep investment losses have caused painful cutbacks at some of the nation’s best-known universities over the most recent fiscal year and have prompted questions about whether their endowments are taking too much risk.

But as the schools, one by one, disclose their numbers, the managers of these endowments are indicating their continued support for a diversified portfolio chock full of alternative investments like hedge funds, private equity and real estate — the very things that have caused so much trouble.

This portfolio strategy is sometimes called the Swensen model, after David F. Swensen, who heads the Yale endowment. On Tuesday, Yale disclosed the details of its year, reporting an investment loss of 24.6 percent, compared with an average drop of 17.2 percent for large funds, according to the Wilshire Trust Universe Comparison Service.

Mebane Faber (of World Beta) sums it up best, by not saying much at all:

Draw your own conclusions on endowment performance last year, fiscal year ending June 30th. Below are facts.

Here are those facts in chart form...



In their defense...

Preferring to emphasize their long-term results, the chiefs of many big endowments, including Harvard, Yale and M.I.T., have indicated they are sticking with their models. Notably, Mr. Swensen did not lay out Yale’s asset allocation for the coming year in his statement — something he has done in years past.

If they are perpetual, long term is what matters... but is there any entity that actually is perpetual?

Source: World Beta

Since the Market Bottomed...

A lot of investors have been caught on the sidelines since the March 9th S&P 500 bottom. Forbes details:

Caught flat-footed when U.S. equities rebounded off their March lows, many investors and asset managers prescribed a cautious strategy and waited for a correction to provide another entry point. But now it's more than five months later and the market has had only a few minor stumbles, leaving many on the sidelines with a dwindling amount of time to pretty up their portfolios by year's end.

The good news? As long as that money wasn't sitting in cash (or Treasuries), they probably did pretty well anyhow. The chart below shows returns since that March 9th date for the S&P, a number of fixed income indices, and commodities.



Source: Barclays

Help Jake Invest...

Back in March, I posted my belief that corporate bonds were a "Screaming Buy". At that time I liked being able to move up in the capital structure, while still being able to receive an 8%+ yield for investment grade and 20%+ for high yield. I detailed I was:

Invested at a ratio of ~70% investment grade / ~30% high yield via an assortment of close-end funds trading at a discount. For the record I do not shy away from risk, so my recommendation would be to tone down the high yield exposure if you are more risk averse.

Since the time of the posting, the investment grade bond ETF (LQD) has rallied 11% and the high yield ETF (JNK) around 20%.

In other words, in just three short months, much of that opportunity has already gone.



WSJ reported on the topic:

Nine months later, investment grade corporate bonds have recovered from the shock of Lehman Brothers’ implosion.

Spreads had taken quite the ride since spiking at the end of 2008. They soared as high as Spreads soared as high as 656 basis points December 5 before returning 100 basis points.

The chart below shows the absolute yield of the Investment Grade Corporate Bond index, as well as the spread to Treasuries. While this is a great sign for corporations that can again finance their operations at levels seen pre-Lehman (i.e. less than 6%), it obviously makes corporate bonds less appealing to investors.



But how much less?

I am still not excited about the prospect of moving down the capital structure (i.e. to equities), especially after the massive rebound in risk assets. So, if I were forced to invest in either equity OR corporate bonds, I would definitely be going the investment grade route. But fortunately, I am not forced to invest.

Thus, the question becomes are investors being compensated enough (via spread) to invest in investment grade corporate bonds over Treasuries (or other higher quality assets). In other words is the spread to Treasuries attractive enough to take on the extra credit risk?

There is nobody better to get answers from than David Rosenberg. And he notes:

Baa corporate yields are between 50bps and 250bps wider than they were at the depths of the last three recessions, suggesting that there is a lot of “bad” news still priced in.

And...

To be sure, corporate spreads have come in a long way from their nearby crisis highs but looking at prior peaks around major events and economic downturns, it does appear as though there is still a lot of very bad news priced into the sector.

But again, after the massive rebound in "anything risk" over the past few months I am not so certain about valuation. After all the economic data I've walked through daily over the past year on EconomPic, I am not so certain that 50-250 bps of additional spread relative to the last three recessions is enough compensation for borderline junk bonds. After the recent rally in Treasuries, I am not so certain that I even like duration like I did just 2 1/2 weeks ago when the yield on a ten year Treasury was 50 bps higher.

And if there is anything I have learned as an investor, if you are uncertain... GET THE HELL OUT.

For that reason (in my trading account - my 401k is another story), I am no longer long anything except for volatility and cash (I'm guessing long time readers have an idea where I'm short), but I am looking for ideas.

And it's Friday, so PLEASE slack off a bit and provide a few.

Source: Barclays

Risk Asset Rebound... Then Why are Insiders Selling

Business Day reports:

Sales by CEOs, directors and senior officers have accelerated to the highest level since June 2007, two months before credit markets froze, as the S&P 500 rebounded from its 12-year low in March. The increase is making investors more skittish because executives presumably have the best information about their companies' prospects.

This follows a 40% jump in the stock market over the past ~3 months (apparently the fastest such rally in 71 years) . So why sell? To understand that lets put that rebound (and all other asset class returns since the last "selling period") in perspective.

The chart below shows the cumulative return of a number of assets class indices since that June 2007 date. While the overall trend was apparent pre-September Lehman collapse (i.e. the more leveraged the asset, the higher the sell-off), the massive divergence between risk asset returns becomes more apparent after that date. It is interesting how much those assets higher in the capital structure hurt (i.e. debt - both investment grade and high yield) have rebounded after forced selling by investors at that time (the returns now actually make sense).



So equities still have a way to go before the are fully recovered and the recent rebound reflects the appearance of a stronger economy you say? Well, take a look at the chart below showing the returns of those same asset classes in the September - February period (i.e. the world is ending period) and the time since. It makes the record rally appear to be nothing more than a partial rebound.



Thus, the question remains... is the rebound really justified for ALL risk assets? If you are to believe insiders, the answer is a resounding no.

Source: Barclays

Hedge Fund Rebound Continues

April



YTD Through April



Source: Barclay Hedge

The New "Distressed" Assets

What Comes Down... Must Go Up

Source: Capital Speculator

Asset Class Returns "Normalizing"?

It amazes me that the same people that were talking about the end of the world in March, are now contemplating we are in "new, lasting bull". The WSJ reports (bold mine):

If stocks have already hit their bottom and are in a new, lasting bull market, then buying them would be the smart move, even though they have already risen some 23% (that is the DJIA, the S&P 500 is up closer to 27%) since March 9. Pessimists warn, however, that the market went on a very similar run from November to January before sinking again to new lows. This is another such bear-market rally, they believe, and new lows are still on the way.

So, do I believe we have seen equity lows? No... my concerns that the U.S. economy is still shedding millions of jobs, has a broke / indebted consumer AND government, and relies on the earnings of "healthy" corporations that can't get decent financing and struggling corporations that are just beginning to default still linger (though when the market does end up hitting its bottom, I will probably be saying those same things).

However, there have been signs of normalization. Asset class returns since the "equity market bottom" are actually "logical" in the sense that higher risk assets are returning more than lower risk assets down the line from equities to Treasuries (unlike what was detailed here).



Though I will say that high yield returns of 15% and equity market returns of 25% in a month and a half sure doesn't feel logical.