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.
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.