After a year like 2013, I can fully understand why many investors are unlikely to have risk on their minds. The one pullback we saw last year, a -7.5% decline in May-June, was quickly reversed with the S&P 500 (SPY) at new highs within a few weeks of the low (see chart below). The “Buy the Dip” mantra has become engrained in the minds of investors as corrections have become a “thing of the past.”
Unfortunately for investors, 2013 was the exception, not the rule. Since 1928, the S&P 500 has had an average of 3.5 corrections per year of greater than 5%. Last year, of course, we only saw one. Additionally, the annualized volatility in stocks last year of 11% was well below the historical average of 16.5% and was actually lower than the volatility of long-duration bonds (TLT).
Early in 2014, investors may be slowly waking up to the fact that things may be different this year, with the S&P 500 down through the first five trading days and asset classes that had performed poorly in 2013 such as Bonds (TLT) and Gold (GLD) up on the year. This is not to say that stocks cannot have a good year in 2014, just that investors should not be expecting this year to mirror 2013 in terms of low volatility and little dispersion (93% of stocks in the S&P 500 finished higher in 2013, a record high).
The key question, then, is what are the major risk factors for investors to watch out for in early 2014? While everyone will have a different answer to this question, these are the 4 risk factors and related charts that I am watching closely in the early going:
1) Interest Rate Spike: With leading economic indicators still pointing upward, the risk of a near-term recession remains low at this point. The main risk that investors face here is rising interest rates. The yield on the 10-year U.S. Treasury Note is currently approaching 3%. While this is still very low by historical standards, at a certain level it will become a headwind for the economy and U.S. equities. With the current trend in rates still up and continued improvement in economic data, a breakout higher above 3% resistance seems likely (see chart below). Back in 2010 and 2011, when the 10-year yield moved above 3.6% it became an issue for equities (we saw corrections of 17% and 21% in those years). If rates continue to rise from here, it will be important to watch the reaction in the equity markets.
2) Defensive Rotation: In confirmation of the risk-on environment, defensive sectors such as Utilities (XLU) have been consistently underperforming the S&P 500 since last April (see declining ratio in chart below). On a weekly basis, the ratio is currently at its most oversold level in the past 10 years. Should this trend begin to reverse, as it did in early 2011, it would likely be an early warning sign of a risk-off move.
3) Credit Weakness: U.S. Credit has been a bastion of strength since the lows in June 2012. The weekly chart below compares the High Yield Credit ETF (HYG) to a 7-10 year Treasury ETF (IEF). The ratio is currently at new highs, indicating the outperformance of High Yield credit which tends to be a favorable backdrop for U.S. equities. You’ll notice that the ratio started declining in early 2011, well in advance of the 21% correction in the S&P 500 that year.
4) Industrial Metals (Copper) underperforming Precious Metals (Gold): The last chart below illustrates the ratio of Copper (JJC) to Gold. Copper is an important industrial metal that is used in construction and manufacturing. When it is outperforming Gold, as it is today, it is generally a bullish backdrop for equities. If this ratio were to show weakness, as it did from 2007 through 2009, that would potentially be a troubling sign for the economy and equity markets.
In summary, don’t become complacent following the outlier year of 2013. Risk management is only effective as an ex ante process. By the time the loss event occurs, it is too late to protect capital. While the above risk factors that I am focusing on are not currently flashing caution, that will not be the case forever. The ATAC models my firm uses for managing our mutual fund and separate accounts are currently invested in U.S. small caps, reflecting a positive near-term outlook for equities. However, we remain focused on risk management and are prepared to rotate into more defensive areas (bonds) when the investing environment changes.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.