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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.

http://capitalcontext.com/wp-content/uploads/2011/06/taa-returns.png


$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.

http://capitalcontext.com/wp-content/uploads/2011/06/taa-upside-vs-downside.png


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.

http://capitalcontext.com/wp-content/uploads/2011/06/taa-indicator.png


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

A-List


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

 

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Thu, 06/02/2011 - 12:35 | 1332704 PaperBear
PaperBear's picture

How much more stuff would you be able buy with 2011 $800 when compared with 1997 $100 ?

Up a lot in nominal terms but up modestly in real terms.

So lame.

Thu, 06/02/2011 - 12:43 | 1332729 Pladizow
Pladizow's picture

Alternative:

Buy a Fixed Equity Index Annuity and get 0% downside risk and probably capture a similar % of the gains.

Thu, 06/02/2011 - 13:08 | 1332887 Missiondweller
Missiondweller's picture

Interestingly, theses were widely mocked in the US as a scam when markets were performing well. Not looking so bad these days.

Thu, 06/02/2011 - 13:14 | 1332912 redpill
redpill's picture

I have a strategy that involves picking the stocks that go up in price the most, it back tests perfectly!!11

Thu, 06/02/2011 - 13:29 | 1332980 TruthInSunshine
TruthInSunshine's picture

I highly recommend Las Vegas Sands at $1.44 in 2009. Buy it but be prepared to sell and even short it aggressively today or even yesterday.

Thu, 06/02/2011 - 12:34 | 1332708 aheady
aheady's picture

That title made me spit out my lunch.

Thu, 06/02/2011 - 13:09 | 1332827 Mercury
Mercury's picture

Last place I expected to see a Judy Blume reference.

You can likely achieve returns somewhat similar to these (vs. the index) via a portfolio of (and the more passive strategy of) low beta stocks. The market timing premise of this one seems like a nail-biter to me.

Thu, 06/02/2011 - 14:30 | 1333319 aheady
aheady's picture

LOL How 'bout it? We must be the same age.

Thu, 06/02/2011 - 14:38 | 1333350 Don Smith
Don Smith's picture

+1.  I LOL'ed, too. 

Thu, 06/02/2011 - 12:36 | 1332715 chartcruzer
chartcruzer's picture

There are a ton of mechanical systems out there to follow that will net phat profits.

Take a look at the PSAR (0.15,0.2) on the SPX

http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3225058&cmd=show[s206018187]&disp=P

Anyone can use for free.

If you leverage up with 2X ETFs,,,,,, $$$$

Thu, 06/02/2011 - 12:42 | 1332724 3.7.77
3.7.77's picture

It seems to have been productive only since QE started.

Not a real good sign, should have just BTFD.

Thu, 06/02/2011 - 12:43 | 1332730 TruthInSunshine
TruthInSunshine's picture

This is awesome!

Would you guarantee me this performance going forward based on your hindsight strategy?

I love all strategies to gain 350%+ that are near certainties based on historical events.

Thu, 06/02/2011 - 13:02 | 1332831 redpill
redpill's picture

 

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.

 

Bouncing between stocks and bonds, what a new and inventive strategy.  Do you have a monthly subscription newsletter too with hot penny stock picks?

 

Thu, 06/02/2011 - 13:34 | 1333013 Greeny
Greeny's picture

When something is "Expensive" absolutely doesn't mean that

it could be even more Expensive, any financial instrument can

stay oversold or overbought much longer than any investor

can stay solvent trading based on those RSI indicators (theory).

Thu, 06/02/2011 - 13:35 | 1333022 leonard1234
leonard1234's picture

Tyler is really impressing me with the wittiness of his titles and comments.  Keep it coming!

Thu, 06/02/2011 - 13:37 | 1333027 Quantum Nucleonics
Quantum Nucleonics's picture

What a stinking pile of crap!  Looking at the chart, your "strategy" tightly correlates with the market right up until the credit crisis.  It's easy to look back at historical data and design a "strategy" that back-tests well, and outperforms the market.

 

Here's mine... Long tech stocks from 1997 to March, 2000, then short tech stocks from March 2000 till the end of 2002.  Pick up some gold below $300 along the way.  Long financials from 2003 till the beginning of 2007, then short financials from 2007 till March 2009.  Then dump it all into a triple leveraged Russell 2000 ETF from March 2009 till last week.  Oh, and pick up some silver in August 2010 and sell it all on April 28th, 2011.

 

How does that back test?  Not too shabby I'll guess.

Fri, 06/03/2011 - 00:54 | 1334897 h3m1ngw4y
h3m1ngw4y's picture

you dont know much about backtesting, do you?

Thu, 06/02/2011 - 13:37 | 1333033 Greeny
Greeny's picture

Besides there is a reason why stocks are "overvalued"

Cause it's no brainer with 0% interest rates and unlimited QE

from the FED. And ain't going to change anytime soon, so?

Guess what? Keep buying treasuries :) *LOL*

Thu, 06/02/2011 - 14:55 | 1333411 TruthInSunshine
TruthInSunshine's picture

I am eagerly awaiting the invention of the time machine, which is when I'm going to absolutely kill it, mofos!

Do NOT follow this link or you will be banned from the site!