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Sector Switching - Playing the Macro theme..

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This study is NOT about Sector Rotation. Continuing our series on playing the macro themes, this research is about utilizing the "Risk On-Risk Off" (instead of business cycle) for timing the Sector investments and to tactically switch between Sectors and Long Term treasuries. I have not seen any studies on the net which approach this way when it comes to playing Sectors. 

Note: For interested readers, this study lends well for applying Sector Rotation concepts as an additional filter. If you do, please drop me an email with your observations.

Coming back, this system basically involves three parts - 
  1. Strategic selection of Sectors to cash on Macro theme
  2. Tactical Switching between Sectors and Long term Treasury Bonds.
  3. Timing the Sector Switches
For this study, the universe of available sectors to invest is S&P sector SPDRs. That doesn't mean one cannot use industry groups or a more granular sector groupings. I chose S&P Sector SPDRs primarily because of their longer price history.

Strategic Selection of Sectors - 

All sectors are NOT equally sensitive to interest rates. Same when it comes to inflationary conditions and future expectations about rates. So why not focus on those sectors that are particularly sensitive? So for this study, the shortlisted sectors are
  • Housing ............................... IYR
  • Energy  ................................ XLE
  • Basic Materials ................... XLB
  • Industrial ............................ XLI
  • Discretionary Spending ...... XLY
Now I have not done any quantitative study to actually measure the sectors sensitiveness. I chose Sectors mostly on conceptual basis. For example, low/decreasing interest rates is good for housing. On other hand, materials prices will have upward pressure in that environment.

Tactical Switching between Sectors & Treasuries -

The study uses TLT as a proxy for Long Term Treasuries. Similarly this research uses  "Equal Weighting" scheme for allocating account capital. 

Note: Interested readers might also want to explore variable weighting scheme (like volatility based weighting) for account allocation to see if that improves results further.

The switching rules between sectors and treasuries are fairly simple. Following are the rules:
  • Divide the account into 5 equal parts as per our Equal Weighting scheme. 
  • Allocate each part (i.e., 20% of the account) to one of the above selected sectors.
  • When timing rule to switch into a sector is triggered (rules given in next section), then invest the allocated part into that sector. 
  • When timing rule tells us to switch to treasuries from a sector, then move the invested amount from that sector to the treasuries. 
Timing the Sector Switches -

 For timing the sector switches, this research uses both "absolute momentum" and "relative momentum". I think we covered in one of the prior posts why it is better to consider both types of momentum. So no point in going over that again. Please drop me a comment or mail if you have any question.

Following are Timing rules to switch between a given Sector & Long term Treasuries. The rules are evaluated over the weekend: 

(Switch to Sector) 
  • Rule:1 -- Sector current week close is greater than the close 13 weeks ago AND the sector returns (percent gain) over last 13 weeks is greater than treasuries return  over the same 13 weeks. 
  •  Rule:2 -- If above rule is met, then close the Treasuries position and switch to cash in coming week. After that switch from cash to that sector in following week.
  • Note: One can theoretically switch position from Treasuries to Sector on same day but practically that is not likely. So this system assumes, there is a 1 week delay in between. Also that allows one to use discretion for getting better entries and exits. The test assumes all entry and exit prices are @ Monday Open price.
(Switch to Treasuries) 
  • Rule:1 -- TLT current week close is greater than the close 13 weeks ago AND the TLT returns (percent gain) over last 13 weeks is greater than matched sector return  over the same 13 weeks. 
  •  Rule:2 -- If above rule is met, then close the Sector position and switch to cash in coming week. After that switch from cash to TLT in following week.
Some Notes - 
  • Usual caveats...Results are frictionless i.e., no slippage or commissions. Calculations are based on closed equity. 
  • Duration: Jan 2002 - Current. (~ 11 years). Time Frame: Weekly.
  • Account Initial Capital - $100k  
  • Benchmark - SP500 Index.
Results -
Following annotated images provide various performance stats.  If the images don't convey information well then please let me know your suggestions/improvements.

 My key takeaways from the results are -
  • The concept of utilizing macro theme for sector switching and timing shows promise.
  • The images provide performance stats at both account & individual sector level. Forensics on the latter provide some pretty interesting stats. See Housing, Discretionary and Material Sectors switches. I can guess logically housing sector switch out performance but have to think bit more about Discretionary and Material sectors out performance. Any comments?
  • Low correlation of the account (as well as individual sector switches) when compared to the benchmark i.e., SP500 index. Makes it a good candidate for strategy diversification.
  • Low drawdown. Makes it a good candidate to apply "Risk Parity" approach. 




Any Thoughts? Comments? Suggestions?
Wish you all good health and good trading!

Disclaimer - 
The above study (or for that matter any thing on this blog) is NOT a recommendation. The study is not for live trading. It will need additional improvements and lot more testing before any consideration for live trading.

Taming the Equity Curve for Better Returns

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Just like markets, each trading strategy creates footprints for the discerning trade/investor to see and capitalize on it. The premise of this post is simple - Can we analyze and take advantage of our trading strategy footprints to improve the Returns, Sharpe and other performance metrics while reducing the draw downs?

 The concept is not that complicated but generally many don't consider it. That included myself. I was using something similar but not same as what is covered in this post though  - a topic for a future post.

 First we need a strategy before we can improve upon its performance. Any one of the numerous studies posted on this blog will fit the bill. But it is more fun doing a new strategy. So below is a strategy with rules to capitalize on a old concept - Turn around Tuesday

Read more »

Risk Switching - Trading macro theme for bigger profits

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I think by now most people might have heard of "Risk on - Risk off" terms in media. Thought it would be interesting to explore this macro theme from various angles. This will take more than one post. What I have currently in mind is to explore topics like
  • Risk switching to enhance popular portfolios like 60-40, Tobias, permanent folio.... 
  • Risk switching to enhance market timing for short term technical trading. 
  • Risk switching in Intra-Asset class instead of inter-asset class (like stocks & bonds). 
  • Risk switching with Forex etc.
Read more »

Inflation Regime Shifts - Implications for Asset Allocation

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Following is an analysis on inflation regime shifts and what it means for asset allocation. It is a bit long article. Below has some fragments I picked from the article. Also a couple of graphs from the article (with my annotations) on asset classes performance in  different inflation regimes.  If you are interested in reading further, the link to source article is at the end of the post.

Over the past thirty years, inflation in the U.S. has averaged just below 3% per year. For many investors, we fear this extended period of price stability has created a complacency about the impact inflation can have on the returns of different asset classes.

But the events that have unfolded since the credit crisis of 2008 should challenge this attitude. The crisis sowed the seeds for the possibility of rising inflation. Central banks have increasingly engaged in unconventional monetary policy, and debt levels among developed market governments have ballooned. Monetization of government debt through inflation could be a logical result.

Further, we believe asset prices are much more sensitive to inflation outcomes relative to expectations than actual inflation levels – i.e., investors can react strongly when outcomes differ from expectations. Historically, inflation regime shifts have occurred with little warning. And once a growth spark ignites the inflation gasoline left everywhere by central banks (most recently the Fed with QE3), it may be too late to hedge the effects of inflation.

Therefore, now may be the time for investors who are concerned about inflationary risks to focus on increasing their exposure to asset classes that tend to provide a positive beta to changes in inflation.

While stocks and bonds have generally performed poorly during periods of high and rising inflation, a number of other asset classes have performed relatively well – including commodities, foreign currencies, gold and TIPS.  


 
Currently there is little in the way on inflation pressures with core inflation running in line with its average of the last 20 years. While it is hard to say with certainty when inflation will move higher, we can identify some of the potential catalysts. 
  • A commodity supply shock, such as the closure of the Straits of Hormuz or widespread regional unrest in the Middle East, is one near-term catalyst that could move inflation materially higher. Recall that in the inflationary episode of the 1970s, it was the Arab Oil Embargo in 1973 that caused inflation to double from 5% to 10%. 
  • Increased demand and decreased level of unemployment. As this happens, the Fed will be faced with making a tradeoff between the two components of their dual mandate, price stability and full employment. It is in making this tradeoff during the coming economic recovery that we see the catalyst for inflation. The Fed may err on the side of seeking greater employment and a stronger recovery, believing that temporarily higher inflation can be reversed.  
  • Central banks globally have been engaged in a series of unconventional policy measures and competitive currency devaluation.   
Source Article: Inflation Regime Shifts

Harvesting asset risk premiums for profits...

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One of my daily morning rituals is to pour myself a nice hot cup of tea, sit in warm morning sun rays and flip through WallStreetCurrents headlines. In recent months, I pretty much stopped looking at other sources besides WSC. For me WallStreetCurrents kind of became a fast and efficient way to keep tabs on markets, viewpoints and more important a continual source of new trade/research ideas. 

 Anyway, so I was flipping through WSC  and when I came to Quant Currents, the first headline that caught my attention was "Dual Momentum". Basically it is a post from Gary Antonacci about his new paper - "Risk Premia Harvesting Through Dual Momentum".

 I became a fan of Gary Antonacci work when I read his prior paper "Risk Premia Harvesting Through Momentum".  I think the Risk Premia papers methodology will be more robust when compared to some of the other popular TAA and AAA papers.

One problem in general with popular papers on TAA and AAA is the reliance on volatility as a proxy for risk. To me, Volatility is NOT same as Risk. Volatility is just an up and down movement and is a good source of profits. Similarly I find volatility targeting though good, the performance differences seems to me is less to do with targeting and more to do with volatility harvesting. I feel there are other ways to do volatility harvesting while treating risk in absolute terms like draw down etc, % capital etc.  How many customers decide to stay/leave a fund based on sharpe, volatility etc compared to absolute metrics like % of their capital loss or gain?
 
Coming back, following is an abstract of Gary Antonacci new paper. I will post my analysis and thoughts on the paper methodology in coming days. If you cannot wait,  the link to full paper is at the end of the abstract.


Momentum is the premier market anomaly. It is nearly universal in its applicability. Rather than focus on momentum applied to particular assets or asset classes, this paper explores momentum with respect to what makes it most effective. We find absolute momentum to be more effective than relative momentum, but that combining the two gives the best results. We also explore the factor most rewarded by momentum - extreme past returns, i.e., price volatility. We identify high volatility through the risk premiums in foreign/U.S. equities, high yield/credit bonds, equity/mortgage REITs, and gold/Treasury bonds. Using modules of asset pairs as building blocks lets us isolate volatility related risk factors and benefit from cross-asset portfolio diversification while using a combination of relative and absolute momentum to capture risk premium profits.

Link: Risk Premia Harvesting Through Dual Momentum

One of the first things traders learn (often hard way) is there is no absolute right and wrong approaches when it comes to profiting in markets. Please feel free to let me know your views. We learn more when our view differ. So the more our views differ the better.

Wish you all good health and good trading!


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