Risks increasing and rewards decreasing in post-monetary stimulus environment

Our strategies’ performance in 2015 was driven primarily by three factors:

  • Rapid sentiment changes and reversals driven by Federal Reserve interest rate decisions

  • Outperformance of the S&P low volatility index relative to the S&P 500

  • Underperformance of the Russell 2000 small cap index relative to the S&P 500

R2K SPLV SP500.png

Huygens’s strategies are all designed to participate in the economic growth experienced by smaller U.S. companies (via the Russell 2000 small cap equity index) while giving some protection against economic downturns.  Our system is designed to minimize trading by riding out smaller index drawdowns, and switching to defensive positioning when conditions are more consistent with a severe decline.  Our Pilot and Mariner strategies trade some of the potential absolute gain of our tactical Russell 2000 exposure for cushion against smaller Russell drawdowns.  This cushion is provided by adding to the portfolio the defensive large-cap equity exposure of the S&P low volatility index (SPLV).

While both indices are highly correlated with the broader U.S. equity market, their smaller cycles tend to be negatively correlated.  The above chart of 2015 U.S. equity index performance shows that in the first half of 2015, the Russell 2000 was the best performing of the three indices, presumably because investor expectations for growth remained high.  In the second half of the year, investor sentiment deteriorated and the defensive SPLV index outperformed the Russell 2000.  The two indices worked together as intended to cushion each others’ fluctuations in our Pilot and Mariner client accounts.  However because the strategies have more Russell exposure than SPLV, the Russell dragged the overall portfolios down relative to the S&P 500.  Our Navigator clients have only the tactical Russell exposure, so its impact was more pronounced for them.

The August / September volatility event, which we discussed in more detail in our 3rd quarter 2015 client note, also contributed to our underperformance relative to the S&P 500. The central bank stimulus of the 2012-2015 period created an investor sentiment environment that depended almost entirely on Federal Reserve Bank actions and commentary rather than on fundamental performance of the overall economy. The volatility event’s rapid onset and equally rapid departure were both driven by expected and actual central bank activity here and abroad. Market reactions to these were quicker than our system is designed to respond to or protect against. The result was that, during this event, our system delivered the protection against volatility and further declines that it is designed to provide, yet it gave up performance relative to the S&P 500 on the first day of the event and the last due to the rapid sentiment changes and large market moves on those days.

Outlook for 2016

2016 is the first year since 2008 in which there is not some form of emergency Federal Reserve economic stimulus (either zero-interest rate policy or quantitative easing) in place at the beginning of the year. We designed our system around the assumption of independent market participants each making their best effort at rational price discovery, and we are hopeful for a return to this process in 2016. What might this mean for equity market performance? We find the following simple analysis enlightening.

Modified Sharpe.png

The modified Sharpe Ratio measures the average return an investor earns per unit of volatility experienced over time.   This chart shows that in the post-crisis era, the absence of central bank stimulus resulted in less return per unit of volatility than stocks’ pre-crisis long-term average.  In other words, without stimulus, risk increased and reward decreased.  We believe this will continue in 2016 as more of the stimulus-era gains are given up while fundamentals-driven price discovery continues.