Guest Post: Are You There Stocks? It's Me, Credit

Tyler Durden's picture

From Capital Context

Interested in a long-only stock index investment strategy that captures 65% of the upside when the index goes up and limits losses to 21% of the downside when the index goes down?
$100 invested in the strategy back in May 1997 would be worth over $800 by early May 2011 compared to less than $300 if you bought and held the index (chart at right).

Most investors would agree that $800 sounds a wee bit better than $268.

$100 dollars invested in the strategy would be worth
over $800 today
compared to less than $300 if a
buy-and-hold policy were used.

There is a saying among credit analysts that "credit anticipates and equity confirms." In other words, the credit market picks up on anticipated trends before the stock market makes its move. While anticipation does not always lead to confirmation (the credit market is not always "right"), confirmation is provided often enough to implement profitable trading strategies, our bread-and-butter at Capital Context.

On average, the TAA strategy captures 65% of
the upside but only 21% of the downside on a monthly basis.

We created a tactical asset allocation (TAA) strategy that outperforms a buy-and-hold policy in a back-test when standard performance metrics are considered

The chart on the left plots monthly Russell 2000 returns (x-axis) against strategy returns (y-axis).
In our back-test of the strategy, we were able to capture 65% of upside equity moves on a monthly basis while only taking 21% of the downside.

Additionally, the strategy can be extended for use with other equity alpha strategies and to achieve complementary portfolio goals like capital preservation.

Details of the strategy, including back-test returns, Sharpe Ratios, information ratios, etc., are provided in the document attached.

Capital Context's credit-informed stock indicator, year
to date. A positive value indicates stocks are cheap. Currently,
stocks are not cheap.

For the past few weeks, we've cryptically alluded to the fact that our in-house TAA model pointed to stock underperformance. We use a top-down relative value indicator to compare BAML's HY/B index (a sub-index of the High Yield Master II) to the Russell 2000. The chart on the right shows the indicator since the beginning of the year. When the value is positive, stocks are cheap. When the indicator is negative, stocks are expensive relative to credit.
Since mid-April, stocks have traded expensive relative to credit and the past week has pushed the indicator far into expensive territory. For now, the high yield credit market is much more pessimistic than the stock market, despite yesterday's equity swoon.

Simply put, the TAA strategy is to hold stocks when the indicator signals they are cheap and hold Treasuries when the indicator signals stocks are expensive. The gauge on the left column of
our homepage

shows where the indicator currently stands and what the implied equity strategy is (be long stocks or be market neutral). We don't use the indicator to short stocks or even to trade credit against stocks. Rather, we have developed a strategy that is accessible to individual investors. Tomorrow, we'll outline a strategy that combines our


with the indicator to further boost the alpha provided.

The credit market is raising the alarm, are you listening?

Capital Context Credit-Informed Tactical Asset Allocation