Emerging Market Rotation Strategy

Along with taking a deeper look at macro trends / releases to try to figure out this whole economy thing (in these all-too-interesting times), I spend quite a bit of my time creating (long-term oriented) trading models. The goal? To better allocate my investments by taking away some of my emotion.

The following model I will walk through is a simple model (available for download here) based on my friend Meb Faber's (of World Beta blog and Cambria Investment Management) Timing Model.

What is it...

It is an Emerging Market "EM" timing model that allocates between two EM sectors... fixed income and equities. As a way of background, since 1999 (I could only pull data for both indices as of December 1998 - due to the methodology below, the start of the model is 10 months later), both EM fixed income and equities have had very similar returns, but have had VERY different ways of getting there (see chart below). At a high level, EM equity tends to outperform when both are trending higher, but EM fixed income outperforms when EM beta struggles.

With that in mind... what is the model? On an end-of-month basis:

• If EM Equity Total Return index > 10-Month moving average, allocate to EM Equities
• If EM Equity Total Return index < 10-Month moving average, allocate to EM Fixed Income

The result? Over this time frame, the rotation strategy has significantly outperformed both EM fixed income and equities with volatility and drawdown levels right between the two (note that a 50/50 blend had returns of around 10.7% with slightly less volatility than the rotation strategy).

If anyone can pull data for EM indices going back further in time, please send my way as I'd like to see how this performs over the longer term.

Source: MSCI, JP Morgan, World Beta

Model: Download here

How Reliable are Yields?

In my previous post Is the Earnings Yield Divergence Unprecedented? we saw that the current differential in the earnings yield of the S&P 500 relative to the yield of the 10 year Treasury is large, but not unprecedented. This post will hopefully provide a bit more insight into the relationship of yield to both fixed income and equity returns.

First, let's start with bonds...

Bonds

The beauty of a traditional bond is that yield wins in the long run... while performance may fluctuate year to year, if you buy a bond and get the credit work right (i.e. it doesn't default), you get a nominal annualized return roughly equal to the yield over a period that matches the duration of the bond (this is the main reason I called out those claiming bonds were in a bubble around this time last year... don't hear much from those guys these days).

The chart below details this feature using bond data from Shiller going back 140 years. To be specific, it shows the Treasury yield at each point in time, then the forward return on an investment in a bond index eight years forward (close to the average duration of a ten year Treasury). While the below does show some noise due to a fluctuating durations (when yields are low, duration is higher) and reinvestment risk, the correlation is 0.92 over that 140 year period (i.e. strong to quite strong). In other words, do not expect to earn more than 2% annualized from an investment in a ten year Treasury bond.

Equities

Equities are a much more difficult beast. There have been countless studies on whether equities actually have duration (one such study showed that equities have a duration of more than 20 years with a standard deviation of 30 years). For this post I ran the 140 years of equity data through an analysis to determine which duration provided the highest correlation between earnings yield and annualized return.

As the following chart details, the winner is.... 10 years.

While ten years was best, eight years was close (and the duration used above for fixed income). Another thought was that if we are to compare earnings yield to the yield of a Treasury bond for relative value, we need an apples to apples comparison... so the chart below uses eight years.

And what do we find... a chart with a pretty strong (~0.45 correlation) relationship. The difference of course lies in the fact that an investor in equities is guaranteed nothing (earnings can fall) and is at risk to multiple (i.e. P/E) contraction, but also shares in the "upside" (i.e. earnings growth) and potential for multiple expansion.

So.... is there a value in comparing the relative attractiveness of equities to fixed income? Sure. I would say the likelihood of equities outperforming Treasuries over the next eight years is high. But don't confuse relative attractiveness and attractive. Ten year Treasuries are currently yielding just 2%, so the 4% "excess" yield of the S&P translates to only 6% on a non-cyclically adjusted basis (using cyclically adjusted earnings it's less than 5%). As the chart above indicates, there have been plenty of occasions where equity performance has significantly under performed its yield, even over extended periods.

Source: Irrational Exuberance

Got Yield?

A month back I detailed that the aggregate bond index (i.e. the Barclays Capital Aggregate made up mainly of Treasuries, Corporates, and Agency MBS) hit an all-time low yield of 2.94%. One month later that looks lofty as the yield to worst hit 2.71%.

Aggregate Bond Index YTW by Sub-Sector



Source: Barclays Capital

Forget Dow 10,000... Agg 3-0-8!

We have a new milestone to watch... the Barclays Capital Aggregate Bond Index (i.e. the most popular US dollar fixed income benchmark) closed at a mere 3.08% on May 21st. That is the lowest level EVER (well, at least since the benchmark's January 1973 inception).



It has since "spiked" to 3.20%.

More on how to add incremental yield here and some perspective on investing in a low return environment here.

Fixed Income: One Long Round Trip Edition

A lot has happened since the summer of 2007, about the time when the word "subprime" entered mainstream culture (fun fact, it was the American Dialect Society's word of the year for 2007).

But, for all that's happened (bank failures, recession, credit freeze, unemployment spike, inflation and deflation concerns, quantitative easing, European sovereign risk, housing collapse, oil spike / freefall, etc...) the Treasury, Investment Grade Corporate, High Yield Corporate, and TIPS fixed income sectors (as measured by their BarCap benchmarks) have almost identical cumulative performance over that time frame.



Source: BarCap

Selecting a Domestic Fixed Income Benchmark

Barclays Aggregate is Yielding Just 3.35%

Last month I detailed that the yield to worst of the Barclays Capital Aggregate Bond Index (i.e. the most popular US dollar fixed income benchmark) was minuscule at just around 3.5%. Well it is now yielding just 3.35% and as a reminder, that is really all you can expect to receive (details here).

As a background, this benchmark is around 40% Government Related bonds, 40% securitized bonds (mainly Agency MBS - i.e. mortgages guaranteed by the government / agencies), and 20% Investment Grade Corporates. With low Treasury yields, rich Agency MBS after $1.25 Trillion in Fed purchases through Q1 '10, and much reduced credit spreads, that 3.35% yield is not necessarily a surprise.

How to Pick up Incremental Yield

There are two main ways for an investor to pick up incremental yield above and beyond that level in this market from their fixed income allocation... move down in quality (i.e. away from Government or Agency MBS to credit) and/or to move out along the yield curve (i.e. the yield curve is STEEP). For this reason, a popular benchmark some investors have moved to is the Long Duration (i.e. out further along the steep yield curve) Government / Credit Index (~50% government related / 50% credit blend).

Risk-Reward

The Long Government / Credit benchmark has a duration of almost 12 years vs. the Aggregate's ~4 years, thus an investor is not only taking more credit risk (i.e. 50% vs. 20%), but significant duration risk (i.e. exposed to interest rate movements by almost 3x more than the Aggregate index - if interest rates move up 1%, the Aggregate underperforms ~4%, whereas the Long Government / Credit underperforms by ~12% all else equal).

But, How Much Incremental Yield will this Add?

A record amount.



In other words, investors are being compensated 1.8% to take on the incremental credit and duration risk.

Breakdown of Incremental Yield

Below is a quick and dirty breakdown of what makes up that 1.8%. The quick and dirty methodology is as follows; the credit portion [red bars] is taken purely as the spread of the Long Government / Credit Index over the Long Treasury Index (i.e. "risk-free" government bonds), whereas what I label 'Yield Curve Positioning' [blue bars] is everything else being compensated for the move from the Aggregate to the Long Gov't Credit (assume for this Q&D that it is only yield curve positioning).



My Thoughts

In my opinion, duration is relatively attractive on a stand-alone basis, but with the incremental yield that compensates one to take that risk, it becomes very attractive in relative terms. However, that is based on my (non-consensus? see here) view that deflation and another downturn is a higher risk over the next 12 months than the risk of increased rates and/or inflation.

On the other hand I am a bit more cautious with regards to the credit risk associated with the 50% allocation to credit. As a substitute for equities? Definitely. But, I wouldn't be too shocked if spreads widen after the record rally we've seen over the past 7-8 months.

Source: Barclays Capital

Corporate Bonds Rockin'

Corporate bonds (investment grade and high yield) are on a tear, up 12% and 40% respectively year to date. How do those figures compare to recent history? Very well.

Annual and cumulative returns of investment grade and high yield corporate bonds are shown below. On an annual basis, we can see that both are on or near record pace, but what I found amazing was how well they've tracked one another over that 20 year time frame cumulatively.

That got me thinking... what would happen if you were to allocate only to investment grade or high yield corporate bonds based upon which was cumulatively underperforming, at the end of each year, since 1989 (i.e. a mechanical method to swap from rich to cheap).

Lets call that the "EconomPic Method". Looking below, we see the EconomPic Method significantly outperformed, returning 600% vs 350% and 370% for investment grade and high yield over the past 20 years (that's more than 10% annualized growth). Compared to the total cumulative return of the S&P 500 during that time period (including dividends) we see outperformance of the EconomPic Method with significantly (understatement) less volatility.

Data mining? Of course! But interesting none-the-less.

Source: Barclays

Just a Rebound?

We've seen similar charts in the past, but the outperformance of high yield (especially compared to Treasuries) has been astounding.



How astounding? Well, what had been an unprecedented sell-off is now an unprecedented rebound.

Fixed Income's Sharp Reversal

A massive reversal in the fixed income market with the high yield index up a WHOPPING 20%+ year to date.



What's so amazing is how fast the reversal has taken place considering most of the underperformance in the credit market didn't really occur until September 2008.



And now... the sell-off and rebound which was technical in nature (i.e. forced selling / opportunistic buying), now becomes a question as to the fundamental value of the security.

Source: Barclays Capital

Abnormal Markets...

High yield bonds are outperforming investment grade corporate bonds, which are outperforming equities (year to date 2009).



How rare is this? Well, this hasn't happened over a full year since 1993 when all three were positive.



And the last time high yield had positive returns, while investment grade bonds and equities had negative returns... well I don't have enough data to tell if that's ever happened.

A Chart Worth 1000 Words? Corporate Bond Spreads (Now vs. Then)

Update: I received some feedback questioning where on the corporate curve I was pulling my data, so I've provided the detail for the original (five year maturity) and update (full corporate and high yield indices).

The spread of a AAA rated corporate bond today = the spread of a single B corporate bond less than two years back.

Original: Spread to Treasuries (5-Year Maturity)


Update: Spread to Treasuries (Full Indices)


Source: Barclays

Where's the Equity Premium? Part III

I've previously compared the S&P to the Barclay's Aggregate Index going back 19 years and before that to the BCAG over the previous 12 years. Now, we have the S&P vs. the Barclay's Government Index over the past 20 years....



Source: Barclay's

GE Rated Aaa = Aaa Joke

In my post regarding the shift in the composition of the Barclays Capital Investment Grade Index, I was asked:

Any idea why most recent data points show Aaa at higher yields than Aa??

In fact, I do... the Aaa (FYI- Barclays Capital refers to this ratings 'tranche' as Aaa, not AAA) is made up predominantly by GE Capital (predominantly is an understatement).



And since mid-2007, spreads on GE Capital bonds have blown out, especially after the Lehman failure in mid-September 2008.



A 450+ bp spread for the CDS (as wide as 600 bp) on a Aaa rated security? As a refresher, an S&P triple A rating is saved for:

The best quality borrowers, reliable and stable (many of them governments)

So why are spreads so wide? According to Morgan Stanley (in reference to GE):

“Investors do not want to own a stock with dividend cut risk. Investors do not want to own a stock with rating agency risk. Investors do not want to own a stock where substantial earnings tailwinds come from past tax reversals. And lastly, investors do not want to own a stock with a financial sub, particularly one which is substantially under-reserved.”

This doesn't sound like a "best quality" "reliable" "stable" or "government-like" entity. Surely the ratings agencies must think differently. Lets get the opinion of S&P analyst Robert Schulz:

The quarterly results show that 2009 may be more difficult than expected for GE Capital. The financial arm makes loans for everything from consumer credit cards to big commercial energy projects.

How difficult? According to Schulz:

Credit losses are now expected to be $10 billion, $1 billion more than GE forecast in December. Losses in the company's real estate portfolio are also expected to reach $4 billion, compared with a $2 billion gain.

So, in the worst financial crisis since the Great Depression, S&P's own analyst declared that after GE needed a $139 billion in FDIC backed debt just two months ago, was put on negative outlook in December, and has its hands in everything from consumer credit cards to big commercial energy projects (again, in the worst financial crisis since the Great Depression) they still deserve a triple A rating.

And this is why the most recent data points show Aaa at higher yields than Aa.

Long Bonds / Short Equities Redux

Back in October, EconomPic Data presented some amazing data that showed there had been no equity premium over the previous 11 3/4 years (i.e. no excess return for equities over bonds). With the continued sell-off in equities and a rebound in credit markets, the Lehman Barclays Capital Aggregate Bond Index has now provided an equal return to the S&P 500 over the PAST 19 YEARS INCLUDING REINVESTED DIVIDENDS / COUPONS!

High Yield: On Pace for the Worst Year on Record

I've seen a lot of charts showing the relative demise of the equity market as compared to past busts (a great one here from Doug Short via The Big Picture).

How have high yield bonds performed? Well, data doesn't go too far back (~25 years), but in a year in which Treasuries have rallied... and rallied hard (i.e. the duration component has had strong returns), the high-yield index has recorded its worst year on record by about 3x that of the previous worst year (1990) and is now down more than 30% YTD through November.



Source: Barclays

Treasuries and Equities Rally

VIX and More points out:

The low yields on U.S. government debt have several interesting implications. One implication is that a falling VIX does not reflect the action in the government bond markets. Another implication is that rising yields will indicate when money is starting to flow out of safe haven investments toward higher risk investments such as stocks. Finally, when the bulk of those currently holding government debt decide that it is appropriate to redeploy these assets into stocks, the pent-up demand for equities will be a formidable factor to reckon with.

And this is precisely what has happened since the credit crisis began last summer, specifically Treasuries have rallied (lower yields), while equities have sold off.



This pattern changed over the last week. Yves at Naked Capitalism is puzzled by:

Long dated Treasuries rising (a deflation signal) as stocks stage a dramatic rally.

She does note that it isn't necessarily just deflation being priced in, but also:

• Short covering of Treasury shorts embedded in structured products to "reduce" their cost
• Shortening of Mortgage Backed Securities required bond investors to buy Treasuries to add duration

My thoughts? It is likely just noise (five trading days before and around a national holiday DOES NOT MAKE A TREND), but if investors continue to flock into both Treasuries and Equities, it is possible all that the liquidity being injected into the system is finally taking hold.

Uncertainty... The Only Thing That's Certain

Volatility continues in all markets. Here we'll take a look at what we've seen in equities and what it all means, as well as in "risk-free" Treasuries, of which investors may be in for a rude awakening at some point in the near future.

Equities (per Bloomberg):

U.S. stocks posted the biggest two-day rally since 1987 after the government guaranteed $306 billion of troubled Citigroup Inc. assets and lawmakers pledged to pass another economic stimulus package.

The last two trading days provided the 12th largest two-day return in Dow history, according to Paul at Infectious Greed (my 11/24 figure is different as it's through the end of day). This must be a great sign, right? Well, 10 of the 11 larger two-day runs took place during the Great Depression. In other words, when markets are as uncertain and illiquid as these (in depression-like markets), expect large moves.



Interest Rates (also Bloomberg):

Treasuries rose for the first time in three days before reports that economists estimate will show consumer confidence held at the lowest level in more than 40 years and house prices extended declines.

It's good to see the volatility isn't only taking place in "risk-assets". HOWEVER, a Treasury sell off (i.e. rising) because consumer confidence may still be as bad as it has been in 40 years... when did that become a sign of improvement?

The Equity Market has Nothing on Credit

Paul Krugman says:

Don't panic about the stock market...

Panic about the credit markets instead. Interest rate on 3-month Treasuries at 0.02%; interest rate on high-yield (junk) bonds over 20%.

This is an economic emergency.

It is unbelievable to me how quickly things have changed. The willingness of an investor to move from a AAA Government Backed Treasury Bill with 90 days to maturity, to a below investment grade (i.e. formerly known as "junk") bond with additional interest rate risk (i.e. more duration) was priced at just over 2.5% per year all the way back in the Spring of 2007 (i.e. 5 lifetimes ago).

At 20%+ interest rate levels, this pretty much knocks out any expected return on equity for most corporations. I have to go with Paul on this... equities still seem priced at high relative (to credit) levels.

What's the Deal with Long Credit?

Below is a chart of the cumulative return of the Long Government Index (U.S Treasuries and agency securities with a maturity of 10+ years) divided by the Long Credit Index (Investment Grade U.S. corporate and specified foreign debentures with a maturity of 10+ years ) since 1978.


From 1978-2007, the two indices performance was remarkably similar, with Long Credit outpacing Treasuries during the bull equity market of the 1980's - 1990's and the "great moderation" we saw from 2003-2007 when risk could be given away, while Treasuries roared back during the period of stress in the early part of this decade (and the the current period of turmoil).

We are at levels truly never seen before, with credit outpacing treasuries by almost 35% over the past year and a half. Questions I keep asking myself:

• Are an unprecedented amount of defaults on the way? Maybe...
  
• Is the recovery value of a defaulted bond less than history would lead us to believe? Maybe...
  
• Are long credit bonds yet another screaming buy? Maybe...
  
• Or are Treasuries just flat out too darn expensive? Maybe...

Until I can answer a few of these better, I'll be keeping most of my money on the sideline.

Source: Barclays

Credit Risk Analysis

Below are the historical yields of the following fixed income indices; Treasury, U.S. Investment Grade / High Yield, and Emerging Market.

Of note is the recent spike in the cost of borrowing for Emerging Market countries. Emerging Markets were supposed to provide the cushion to our global economy, but as the NY Times pointed out on October 7th:

Many of the world’s fastest-growing economies thought they had insulated themselves from problems in the developed world. But economists said that simultaneous turmoil in Europe and the United States was too much to bear. “The potential of a global recession is awakening emerging markets that they will be hit stronger than we thought before,” Alfredo Coutiño, a senior economist at Moody’s, the credit rating agency, told The Times.

Source: Barclays