Huygens equity market stress indicator quickly returns to bullish positioning despite noise and confusion surrounding presidential election

The weeks since early November 2016 are emblematic of a period when a quantitative indicator of true stock market stress can be most helpful to protect investors from their psychological biases.  You may recall that many respectable economists predicted severe and immediate financial market panic if Donald Trump won.  

On election night, at roughly 2:30 AM when Fox News first called the election for Donald Trump, Walt received a call from a close friend (who is however not a Huygens client).  “Is there any way I can sell all my mutual funds before the market opens tomorrow?” he asked.  At the time of that phone call, U.S. equity index futures were dropping precipitously.   

The panic quickly subsided. Within a day of the election, our market stress indicator turned offensive and has stayed in that state ever since, and as a result our strategies have captured much of the ensuing strong equity market run. An individual’s natural response would have been to expect volatility to resume, and therefore to wait on the sidelines for a better market entry point. Our system recommended otherwise, to our clients’ benefit.

Earlier in 2016, we pointed out that equity market stress, as measured by rolling 12-month volatility of daily returns, has been continuing its long decline from the 2008-9 global financial crisis, despite having reached a recent minor peak in February of 2016.  The Kansas City Federal Reserve Bank’s index of financial market stress, which combines measures of stress in multiple financial markets including equity, debt, and foreign exchange markets, illustrates this well:

KC Fed stress index.png

Huygens market stress indicator correctly maintained bullish positioning in the quarter & captured stocks' gains, at a time when recession seemed imminent but never arrived.

Despite current jitters over the upcoming elections, the U.S. economy continues to improve, albeit slowly.  The Conference Board’s Leading and Coincident Economic Indicator Indices both signal that a downturn in economic activity has not yet arrived.

Source: The Conference Board

Source: The Conference Board

At the core of our strategies is a system for determining when to have offensive or defensive exposure to U.S. equities.  While there is certainly benefit to a system that can move to a defensive position before an equity market selloff has reached its bottom, it can be equally beneficial for that system to maintain an offensive positioning when emotions might otherwise lead a human investor to play it safe.  Thus our system has maintained its offensive positioning for all but four trading days this year, capturing the Russell 2000’s strong recovery since February.

In past client notes we have commented on our study of regimes in financial market behavior.  The below chart graphs rolling 12-month standard deviation of daily returns to illustrate long-term behavioral regimes in the U.S. large-cap equity market.  Volatility has been in a continued decline since the 2008-9 financial crisis.  Recent bursts of volatility in 2015 and early 2016 were driven mostly by fears of aggressive central bank tightening, not by true underlying economic weakness.  Now that the tightening has not materialized, volatility has resumed its long, slow decline.

S&P realized vol.png

As you know, the Huygens Market Stress Indicator system monitors equity market volatility daily in order to react to any sudden and severe changes in equity market sentiment. The general lack of change in our system’s positioning in 2016 seems consistent with the ongoing (if slow-moving) economic recovery, and the large-scale decline in equity market volatility.

Like you, we wait with some anxiety to see what early November brings.Regardless, we continue to monitor equity market stress daily and react accordingly.

Huygens market stress indicator correctly stayed bullish at quarter end as US Central Bank interest rate stimulus cushioned US stocks against Brexit volatility and ongoing earnings softness

The story of the quarter is straightforward.  In our previous two client notes, we noted the marked underperformance of the Russell 2000 small cap index relative to the S&P 500, but commented in our Q1 2016 note that the worst of this divergence was likely over.  We pointed out that it was driven by two factors: the Russell 2000’s overexposure to energy, and the S&P 500’s overexposure to corporate buybacks.  With oil prices recovering and stabilizing since February 2016, and with the volume of corporate buybacks declining in 2016, the Russell 2000 outperformed the S&P 500 by 6% off the early February bottom.  See the chart below.

Russell SPLV SP500 chart.png

In addition, the S&P large cap low-volatility index also outperformed the S&P 500.  This index tends to overweight high dividend-paying stocks.  At the start of 2016, the U.S. Federal Reserve Bank (FRB) had signaled it would likely increase interest rates 4 times in the year, but several indicators of economic growth, including inflation, job creation, and wage growth, were low enough to force the FRB to reconsider.  Its current messaging is that it may only raise interest rates once or twice, and as a result dividend-paying stocks have outperformed the broader index.

We finally also note the very brief burst of volatility surrounding the UK’s decision to leave the EU.  Our market stress indicator correctly remained offensive during the whole episode, and equity market performance quickly validated that call.

In sum, several things went our way this quarter.

Is a recession already underway? Decreasing total US market cap + flat large cap stock prices + falling small cap stock prices = corporate buybacks the main support for S&P 500 stocks

The nearly flat performance of U.S. equity indices and of our Pilot strategies in the first three months of 2016 belie the full story of the quarter.  The divergence between the Russell 2000 and the S&P 500, which we first mentioned in our Q4 2015 note, continued and accelerated.  The below chart shows the relative change in the equity indices our strategies use versus the S&P 500 over the past two years.  During most of this time, the Russell has lagged the S&P 500.  The lowest-volatility names of the S&P 500 - generally defensive stocks such as utilities and consumer staples - performed best. 

Russell SPLV SP500 chart.png

In mid-2015 it appeared the small-cap vs. large-cap performance gap was closing, but instead it widened further, with the Russell underperforming the S&P by 11.0% since June 29, 2015.  More than half of that gap occurred in the fraught first six weeks of 2016.  We believe the ongoing divergence has been driven by falling oil prices (disproportionately negative for small-caps), and corporate buybacks (disproportionately positive for large caps).

Source: Yardeni.com

Source: Yardeni.com

The above and following charts, from Yardeni Research, show that energy is having more impact on the small-cap universe than the large-cap.  The S&P 600 is a U.S. small-cap index, essentially comprising the 600 largest companies of the Russell 2000 index that we use.  The charts show the relative expected earnings contribution of each industry segment to the earnings of the overall index.  At the start of 2014, energy was by far the largest contributor to small cap expected earnings, but in 2015 that contribution declined dramatically and turned negative.  Energy earnings expectations briefly improved in mid-2015, but then deteriorated further into negative territory through Q1 2016. 

Source: Yardeni.com

Source: Yardeni.com

Energy was also a drag on the S&P 500 large-cap index over this time, however its relative contribution to index earnings wasn’t as large to begin with in 2014, plus large-cap energy companies have managed to keep their earnings positive.

Now consider the Thomson-Reuters U.S. equity mutual fund flow data below. It shows that aside from 2013-14, investor capital has been steadily flowing out of U.S. equities, with the outflow accelerating to an annualized rate of $66B in Q1 2016.

Equity fund flows.png

Consider also that, according to the World Bank, U.S. equity market capitalization shrank by 4.8% in 2015, from $26.3 trillion to $25.1.  Corporate buybacks, a mainly large-cap phenomenon, help explain what has been supporting the S&P 500 index as market capitalization declined and investor capital flowed out of the market.  According to the below Factset Research chart of trailing-twelve-month U.S. buybacks, the annual value of corporate share buybacks has remained near its pre-financial crisis peak, even as earnings have declined.  These buybacks simultaneously put upward pressure on equity prices, and return capital to shareholders reducing market capitalization. 

Source: FactSet

Source: FactSet

Projecting these two trends forward, it appears that the worst of the large-cap / small-cap divergence may be over.  If S&P 500 earnings don’t rebound from their ongoing decline (light green bars in the above chart), companies may choose to deploy more of their net income into growth projects rather than return it to shareholders through buybacks.  Regarding energy, WTI crude oil prices have recently risen 43% since February to $45.92 / bbl, a level not seen since December.

This may not mean that the economy has turned a corner.In fact, the below Yardeni Research chart shows that when S&P 500 revenues have declined for multiple quarters as they have recently, a recession was already underway. Stay tuned.

Source: Yardeni.com

Source: Yardeni.com

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.

Declining S&P revenues and profits driving equity market stress

The primary story of the third quarter was the August / September volatility event, which coincided with a period of global economic weakness and uncertainty.  The below chart from Yardeni Research illustrates the challenge faced by the U.S. economy, and therefore the U.S. equity market, in 2015.  The OECD index of U.S. leading economic indicators (the blue line) has been predicting a slowdown for most of 2015.  At the same time, S&P 500 revenues per share (the red line) have declined in 2015 from their year-ago levels and are on track to do so again in the third quarter, according to Factset Research’s most recent Earnings Insight report.

Source: Yardeni.com

Source: Yardeni.com

In late August, these factors plus a host of others – concern over a potential Federal Reserve interest rate increase, a stock market selloff in China and the Chinese government’s resulting surprise currency devaluation, persistent declines in commodity prices – all contributed to a burst of volatility in U.S. equities. 

The chart below shows that our Market Stress Indicator switched to Defense at market close Friday August 21.At the time, the S&P 500 was in the throes of its steepest decline since August 2011. In fact at market open August 24th, when our portfolios repositioned, equity indices were already down substantially from Friday’s close. Our Indicator remained in the Defense state for 30 trading days, the longest such period since we introduced our system four years ago. This period represented a classic investor sentiment regime shift from one of optimism to a regime of pessimism and fear, characterized by much higher than average daily volatility and abrupt reversals in equity market direction.

Signal vs S&P 500.png

During this 30-day period, the S&P 500’s daily volatility more than doubled to 1.83%, from 0.75% in 2015 through August 20th.  Over the past ten years, this level of volatility has only been seen during the market selloff of 2008-9, and the steep S&P 500 corrections of 2010 and 2011. 

Market downside volatility abruptly ceased on October 2nd, protecting the S&P 500 from further declines past its 12.4% peak-to-trough decline reached at the start of the volatility event in August.  The catalyst was most likely that morning’s disappointing Non-Farm Payrolls (NFP) report, which convinced investors that the Federal Reserve was unlikely to raise interest rates before its December meeting. 

In our view, this last point illustrates the U.S. equity market’s ongoing dependency on stimulus measures, and the risk of further volatility once these measures are unwound.  The October 2nd NFP report was disappointing in several areas: job creation was shown to be slowing, hourly wages declined, and average hours worked declined.  Such a report would normally depress equities due to its implications for future economic growth.  However, by making it difficult for the Federal Reserve to justify raising rates, in this instance it quieted volatility and ignited a recovery in U.S. equities that has continued through October, a continuation of the “bad-news-is-good-news” equity cycle induced by ongoing stimulus.

At the end of the third quarter of 2015, the Russell 2000 stood at 1100.69, a level it first reached nearly two years before, on October 17th 2013.Sideways trading in U.S. equities continues, without a meaningful break one way or the other.We wait along with you for the return of a trend.

Huygens system particularly relevant in confusing rare environment of narrow trading range, low volatility, few up days, and declining company revenues and profits

During the second quarter of 2015, our market stress indicator remained consistently in the offensive portfolio state.  All U.S. equity indices traded within a historically narrow range and ended the quarter essentially flat.  In fact, the narrow S&P 500 range in the first six months of 2015 placed the period in the lowest decile of all 6-month periods ranked by trading range going back to 1953.  Such a narrow range is rare, but not predictive of future returns.  In the middle 1990s the S&P 500 broke out of its narrow range to resume the strong bull market trend of that decade, but in 2007 the range breakout occurred to the downside with the global financial crisis.  What is clear is that periods of such low volatility are anomalous and not representative of the normal state of the equity market.

S&P 500 past 6 month trading range.png

The first half of 2015 was also notable when ranked on the basis of percent up days.  The chart below shows the S&P 500 returns in all six-month periods since 1953, grouped into deciles on the basis of the portion of days in the period with positive S&P 500 returns.  The relationship shown makes intuitive sense: those periods with fewer positive S&P 500 days are more likely to have had worse total return than those with more positive return days. The January to June 2015 period is notable because, on the basis of percent up days, it ranked in the second worst decile (marked in purple).

S&P 500 past 6 mo return.png

Nearly every period in that decile going back to 1953 had a negative S&P 500 return, and the median return in that decile is -4.7%.   The first half of 2015 was one of the very few 6-month periods of the past 60 years having such a low percentage of up days, and still delivering a positive return for the S&P 500: +0.20%.   

By any measure, the S&P 500 and other U.S. equity indices continue to trade within a remarkably tight range.  It remains to be seen which direction equities will break when the trading range normalizes.  Our indicator system monitors equity market stress on a daily basis, and when economic indicators are uncertain, as they are now, the downside protection it affords can be especially valuable.

As of this writing, the second quarter earnings season is in full swing.  Factset’s July 24th Earnings Insight predicts that when all S&P 500 companies have reported for the April to June quarter, the results will show blended revenue and earnings declines of 4.0% and 2.2% respectively, relative to the second quarter of 2014.  Given such performance, the stable condition of equity markets remains surprising.  In the past two quarters, revenue and earnings declines were limited to the energy sector.  However in the second quarter, according to Factset’s predictions, utilities and materials also experienced revenue and earnings declines.  Furthermore, blended S&P 500 revenues are expected to continue declining through the end of 2015.

As you know, we monitor market and economic circumstances regularly to confirm that our products are performing as designed. We believe it’s when economic indicators are uncertain, as they are now, that the downside protection afforded by our approach can be especially valuable.

US company earnings declining amid deflationary environment in many developed economies around the world

After many months of trending steadily higher from late 2012 through year-end 2014, U.S. equities have generally entered a quiescent state.  In our previous note, we pointed out that the small-cap Russell 2000 had been within a narrow range since Q4 of 2013.  As the S&P’s Q1 2015 return indicates, the large cap index has now entered a similar range.

Although the equity indices lacked any clear direction, the S&P 500 has experienced significantly more day-to-day fluctuation in the past two quarters than in the eight quarters that preceded them.The chart below demonstrates that the index’s recent increase in realized volatility to more typical historical levels is consistent with the end of U.S. quantitative easing.

Vol trend chart.png

Recall that our strategies are designed to use implied volatility, not realized, as a measure of institutional investor sentiment and therefore as a proxy for potential large imbalances in supply and demand for equities.  We consider S&P 500 put option implied volatility to indicate a normalized price that institutional investors are willing to pay for downside protection.  Despite the increase in realized volatility during the quarter, implied volatility remained predominantly at below average levels, consistent with bullish institutional investor sentiment.  As such, aside from four days early in the quarter, our strategies maintained an offensive positioning toward U.S. equities.  

Given the negative S&P 500 company Q1 guidance, analyst projections, and actual performance, we were surprised by the generally static condition of the S&P 500 index.According to Factset’s April 24th Earnings Insight, Q1 2015 S&P 500 revenues declined 3.5% from the same period a year ago, and aggregate earnings have declined 2.8% (based on the 40% of companies that have reported).If the remaining companies’ Q1 reports are consistent with this trend, Q1 2015 will be the worst quarter for the S&P 500 since the third quarter of 2009.Furthermore, the report indicates that consensus analyst estimates show revenues and earnings continuing to decline on a year-over-year basis through at least Q3 2015. There are several possible reasons to explain why the index hasn’t fallen:

  • Investors could be pricing the S&P 500 based on their performance expectations for 2016 and beyond.

  • Earnings per share have continued to increase, despite falling aggregate earnings, thanks to companies’ ongoing share buybacks.

  • Investors believe that as long as the Federal Reserve remains accommodative, it is unwise to bet against equities.

Perhaps each of these factors, among others, is important.  They all depend to some degree on a continuation of the Federal Reserve’s current accommodation.   In this context, it is important to note that broad inflation continues to be absent from the U.S. economy, despite nearly full employment and a burgeoning rebound in oil prices.   In fact, Institutional Investor recently ran a short piece titled, “Deflationary forces are gaining strength around the world.”  It demonstrated that since 2012, many developed economies around the world have been experiencing outright deflation, and many more are experiencing inflation rates below 1%.

Our conclusion is that, with U.S. company revenues and earnings likely to fall through the remainder of 2015, plus persistent general deflationary forces around the globe, we believe it is unlikely that there will be any meaningful change to the current interest rate environment this year.  It remains to be seen whether bullish U.S. equity sentiment will persist.  We continue to monitor equity markets daily, as we endeavor to position our clients to benefit should a downturn arrive.

After wind-down of US Central Bank monetary stimulus, equity market facing substantial headwinds in 2015

Outlook for 2015

Our investment strategies benefit most when the Russell 2000 experiences a wide trading range over the course of several months. Our focus here is to assess the potential for an increased Russell 2000 trading range in 2015, rather than discussing conventional macroeconomic topics or their potential impact on equity valuations. 

Factors we think could minimize the Russell’s trading range in 2015:

  • European quantitative easing:  For several reasons, we think the European QE program is likely to have less positive impact on U.S. equities than the U.S. program had.  However, by injecting large amounts of capital into global asset markets, we think it reduces the likelihood of a sharp selloff in U.S. equities in 2015.

  • U.S. interest rates:  Maintaining the consumer inflation rate at 2% per year is half of the Federal Reserve’s dual mandate (the other half being the maintenance of maximum employment).  Inflation has remained subdued globally, and the collapse in oil prices in the second half of 2014 has caused U.S. consumer inflation to stop rising and hold at a level below the FRB’s 2% target.  This might cause the FRB to delay raising interest rates, and by removing a potential source of downward pressure on earnings multiples, this could also reduce the likelihood of a sharp selloff in U.S. equities

  • The decline in the “oil tax”:  According to an analysis by UBS, each $10 decline in the price of oil contributes 0.1% to U.S. GDP.  Oil’s $60 decline since June of 2014 implies a 0.6% contribution to GDP, which may not be sufficient to power strong growth by itself, but which can help counter other potential economic headwinds.

Factors we think could maximize the Russell’s trading range in 2015:

  • Stretched equity market valuations: Here we refer to an analysis by James Paulsen, chief investment strategist of the Wells Capital Management subsidiary of Wells Fargo.The S&P 500 currently trades at 18 times trailing 12 months earnings, which is in the 74th percentile of multiples in the post-WWII era.High but not outrageously high, historically speaking.However, the median price-to-earnings ratio and price-to-cash-flow ratios of all NYSE stocks are currently at record levels.The implication is that, on average, the broad U.S. equity market is more expensive now than it ever has been, leaving little margin for error should a hiccup occur in earnings growth.We also note Jeffrey Gundlach’s observation that since 1871, U.S. equities have never risen seven consecutive years.

Source: Wells Capital Management

Source: Wells Capital Management

  • Credit market stress:  Below, we have updated a chart we included in last quarter’s note.  In late 2012, high yield and government fixed income instrument valuations diverged, in anticipation of U.S. economic growth resulting from QE3.  In 2013, the instruments moved in unison as interest rate expectations changed.  Beginning June 2014, high yield has underperformed government debt, partly due to the end of QE, but also perhaps indicative of concerns about credit quality among corporate borrowers.  This has been attributed mainly to highly leveraged “fracking” oil producers, who borrowed heavily from mid-western regional banks to expand production.  As oil prices have fallen since mid-2014, these producers have struggled to remain solvent.  While this is a typical credit cycle that could remain contained within the oil sector, it is possible that regional bank balance sheets will be sufficiently damaged to result in reduced credit availability in other industries.

HYG vs IEF.png
  • China slowdown contagion:  According to a recent Fortune Magazine analysis, real estate accounts for 25-30% of China GDP, when the entire construction value chain is considered (including upstream raw materials and downstream furnishings).  More than 60 million vacant apartments currently sit unsold throughout China, and housing prices nationally declined 4.5% in 2014.  Chinese construction has been the primary driver of global commodity markets in recent years, and the current slowdown has been coincident with the decline in many hard commodities.  We believe this slowdown will continue, and will cause rising credit stress in those economies dominated by commodities production.  Declining foreign trade can then spread this stress to developed markets.

“Ghost city” of unsold apartments in Yingkou, China (Wall Street Journal, 14 Apr 2014)

“Ghost city” of unsold apartments in Yingkou, China (Wall Street Journal, 14 Apr 2014)

In sum, in 2015 the global economy is already facing more stresses than it did in 2014.  Although ongoing central bank activity has the potential to cushion the equity market swings that may result, we think we are unlikely to see another trend-free year for the Russell 2000.

Wind-down of US Central Bank monetary stimulus inducing market volatility and suppressing returns; Huygens introduces tactical asset allocation strategies

The ongoing theme of this year continues to be the increase in U.S. equity market volatility in response to the termination of quantitative easing, and the open question as to how financial markets will react longer term following the end of QE.  Throughout most of the program, which began in mid-November 2012, risk assets outperformed defensive ones.  The first two charts below show the Russell 2000 outperforming the S&P Low Volatility Index (an index comprised of 100 defensive components of the S&P 500), and high yield bonds outperforming 10-year treasuries, through February of 2014.

R2K & HY vs VIX over time.png

Beginning in March of 2014 (vertical line 1), these performance gaps began to close, four months after the Federal Reserve commenced the program’s taper.  Then in July of 2014 (vertical line 2), high yield bonds and small cap stocks began to sell off precipitously, while the CBOE VIX index rose.  This process continued through the end of the third quarter.  Although the VIX rose substantially in the third quarter relative to its July 3rd low of 10.32, in absolute terms it remained below its long-run average, which is consistent with a risk-on regime.

Our assessment is that this underperformance by the Russell 2000 relative to large cap indices, during a period of continued risk-on sentiment, is a reversal of the phenomenon witnessed at the beginning of QE.  Just as large amounts of liquidity being injected into financial markets benefited risk assets more than defensive ones, the decline in this liquidity as QE has been tapered is having the reverse effect.  Our strategies gain their equity exposure primarily via the Russell 2000 ETF (IWM) and the S&P Low Volatility ETF (SPLV), so a period such as this will cause our strategies to underperform the broader indices.  This pattern of risk assets underperforming defensive ones can be an early sign of a change in equity market sentiment.  It is also the main reason our strategies typically have their worst relative performance in the later stages of bull markets.  

Outlook

QE has continued for nearly two years, and if the Federal Reserve stays on course the program will be terminated at the next FOMC meeting on Oct 29th.  The distortions it has caused across many financial markets have been widely reported.  The program was experimental, and its merits and drawbacks will likely be debated for years.  Our view is simply that the moment has finally arrived when normal market forces will return to their role as the primary drivers of financial markets, for better or worse.  We have said before that this transition is likely to feel somewhat rocky.  In fact, the four weeks ending Oct 15th saw the S&P 500 undergo a 7.4% drawdown, its steepest since QE began.  By comparison, between March of 2003 and December of 2006, a period of relatively low volatility and dramatic growth for U.S. equities in which the S&P 500 rose 64.7%, there were three such 7%+ drawdowns. 

European economic growth has not recovered at the same rate as that in the U.S.  Eurozone unemployment remained at 11.5% as of September, near its peak of 12.2% during the financial crisis, and retail sales there have been declining, particularly in Germany.  Several analysts have attributed the early October U.S. equity market volatility to concerns about Eurozone growth, because large cap U.S. companies generate significant earnings overseas.  To encourage higher growth rates and inflation, the European Central Bank introduced negative interest rates and has begun a new quantitative easing program of its own. Due to the process of arbitrage across asset classes and geographies, this QE program is likely to have some positive impact on U.S. equities, despite its likely smaller size than that of the U.S.  Note that the S&P’s recent bottom occurred within days of the ECB’s announcement that it had commenced buying asset-backed bonds. 

Huygens Business Update

Some of you may be aware of a new segment of the asset management industry known as ‘liquid alternatives.’  These are hedge fund-like strategies distributed either in a mutual fund structure, or via financial advisors using separately managed accounts.  The liquid alternatives segment has been the fastest-growing market segment in all of asset management since 2011.  Retail investors were the early adopters of these strategies, however more recently institutional usage has risen significantly.

These products are generally tactical and systematic in design, and because of the way they are distributed, they offer their clients daily liquidity.  Our approach of systematically trading highly liquid index ETFs lends itself well to this market.  Our long-term vision for our firm has always been to offer a suite of complementary investment products, all differentiated by our proprietary system for identifying regime changes in U.S. equity market risk appetite.  As a result, we have developed and introduced the Pilot line of products for the liquid alternatives market. 

Our Pilot products are tactical asset allocation strategies, rotating among U.S. equities and 10-year treasuries ETFs in response to the same Navigator indicator that drives our current strategies. In September of this year we completed our registration as an investment advisor in New York, which was a necessary step for the growth of our business generally, but was particularly necessary for the launch of our Pilot products.We would be happy to discuss these products, or anything else in this letter, with you more at your convenience.