For ATACX, RORO, And JOJO, Everything Is About To Change
2022.05.22 13:31
“The one fact pertaining to all conditions is that they will change.” – Charles H. Dow
In a perfect world, asset prices would be based on measured fundamentals.
Unfortunately, that’s not the case. Investors include all sorts of variables—personal preferences, future potential, emotion—in their security selection processes.
That’s why anomalies exist. These are the things that occur when investors don’t think they should. It’s what makes investing a constant challenge.
We’re seeing a significant anomaly in the relationship between stocks and Treasuries right now, which may have ended the week of May 9 (more on this later).
The S&P 500 and Treasuries usually have a negative correlation with each other during high volatility, high stress periods for equities. This is at the core of all of the research papers I’m known for.
Historically, Treasuries are the best defensive asset when stocks are suffering a drawdown (yes—even in the 1970s based on the sequence of returns).
But that’s not what we’re seeing in 2022, and explains precisely why the ATAC Rotation Fund (ATACX), the ATAC US Rotation ETF (NYSE:RORO), and the ATAC Credit Rotation ETF (JOJO) have had such a difficult time rotating risk-on, risk-off.
S&P 500 Total Return Level, Bloomberg UST Level Correlation
The correlation between the equities and Treasuries hasn’t just turned positive. It’s turned significantly positive. At precisely the time when many investors would likely be turning to Treasuries for safety, government bonds posted one of their sharpest and steepest declines in history.
Treasuries should be behaving like a risk-off asset, but they’re not.
I’ve called this on Twitter the Black Swan of Black Swans. The extreme within extremes because it’s happening at the exact same time as stocks broke down.
What do you do when risk-off is acting like risk-on?
Bloomberg UST Level % Off Highs
It is easy to say that with hindsight, inflation and the U.S. Federal Reserve Board (the Fed), are the reason for this. But I don’t believe that’s the full story.
As inflation remains above 8% in the U.S. and the Fed scrambles to raise interest rates in order to fight it, yields headed up instead of down, disregarding duration, and recession risks that spiking rates cause on an economy.
The ATAC Rotation Fund (ATACX), the ATAC U.S. Rotation ETF (RORO), and the ATAC Credit Rotation ETF (JOJO) all use intermarket relationships as signals for whether to position the portfolio aggressively or defensively.
Historically, following these signals has given the funds good opportunities to produce above average risk-adjusted returns over time.
This is not a situation necessarily where it’s the signals that aren’t working depending on the Fund. It’s the opportunity set that isn’t.
When anomalies exist in the financial markets, all bets can be off.
This dynamic has been extremely painful in particular for RORO because when going risk-on in equities, it uses a bit of leverage to go into stocks purposely. Why? Because it’s the only way to play “catch-up” from all the times the risk-off trigger is signaled, and markets go up while in the false positive of Treasuries.
ATACX has a similar dynamic using 1.3x leverage when risk-on in equities, but because that Fund has a short-duration trigger, it has fared significantly better in the mayhem.
RORO uses the relationship of lumber to gold to determine risk-on, risk-off positioning. Lumber has been incredibly volatile since the COVID pandemic and its price has been driven as much by housing market shortages and supply chain disruptions as traditional risk-on/risk-off dynamics.
Even the price of gold, which has historically been thought to rise in value as inflation rises, has struggled to generate gains.
All of these behaviors, which have often worked historically, have instead been the anomaly. The COVID pandemic has created a number of unusual circumstances—trillions of dollars in stimulus cash, record low interest rates, a ballooning Fed balance sheet, an incredible bull market in housing—for which the markets have little precedent.
That’s rendered traditional risk-on/risk-off strategies less effective today than they have been in the past. As a matter of fact, it’s resulted in a historic drawdown as everything has collapsed in the same way.
Eventually, we’ll return to an environment where investors treat Treasuries as a safe haven asset. Eventually, we’ll see lumber be a better reflection of overall economic conditions and not just a product of supply and demand shocks.
All I can say with confidence is that this is an incredible dislocation happening in markets, and that generally, the best returns tend to come from buying after a large drawdown.
Why did I mention the week of May 9, 2022 earlier? Because that was the first week all year where Treasuries acted risk-off again—where a flight-to-safety bid took place in government debt, consistent with how it behaves when stocks become volatile.
I have said many times that this environment is in many ways worse than 2008 and 2020 for markets because Treasuries are not acting in the way they historically should.
2022 has been a good reminder that the markets aren’t always “normal.” Periods, such as the tech bubble, the financial crisis, and the COVID pandemic, are rare, but they do happen from time to time.
We live in the small sample.
We live in the anomaly.
It is my sincere hope things will normalize again, because if they don’t, the implications on the entire financial system are more significant than I believe most can imagine.
A highly indebted country cannot survive when assets are falling and rates are rising in the way they have this year.
Even though ATACX, RORO, and JOJO may have not worked in crazy environments like this one, due to anomalies, false signals or emotion-driven investing, the underlying research is factual, quantitative, and undeniable. ATACX is a testament to that in the way it behaved in 2020.
I believe everything is about to change in a way that at least allows for the potential for the funds, and opportunity set, to revert to historical behavior.
At some point.
