BTS Asset Management

Q1 - 2019 | by Matthew Pasts, CMT, CEO, BTS Asset Management, Inc.

Getting Our Risk On After Clearing A Higher Bar

After more than a month of choppy markets, a strong price trend took shape in credit markets—so strong that it overshadowed less-than-bullish signals from the VIX volatility index¹—and we ushered in the month of February by rotating into high yield.

The move is a good illustration of how our multifactor models and rules-based investment process seeks to digest market data that is sometimes conflicting and, only after a strong trend emerges, produces a buy or sell indication. Over the years, BTS has developed a series of price filtering indicators to gauge the strength and sustainability of upward price movement. Our price filters have the potential to help us get in ahead of a sustained rally in risk assets, or they can mean potentially avoiding reentering credit too early.

The latter was the case in the second half of 2011 when there were similar signs of a rally in high yield, but our price filters were still flashing strong warning signals. We stayed out and avoided a significant widening in spreads. Indicators invested assets on strong confirmation of trend. Volatility and drawdown were avoided in favor of investing into a stable trend upon confirmation of price strength—some gains were missed to avoid subjecting assets to a credit event such as 2008 - but after the buy allocation, follow through was steady and strong into 2012.²

Ahead of the latest move, there were a number of fundamental factors that provided a strong backdrop for risk assets:

The Federal Reserve appeared to back away from its hawkish posture on monetary policy. In the weeks following the December Federal Open Markets Committee meeting, FOMC members made multiple public pronouncements that walked back some of the more aggressive rhetoric that emerged from the December meeting. That lifted stocks off their December lows and headed off what at one point looked like a possible compounding credit selloff. Fed policymakers’ more dovish comments were later confirmed at the January FOMC meeting.
The January employment report was a blowout and, coupled with an equally strong December print, suggests that the U.S. consumer will remain strong. The strong jobs figures and the apparent absence of pressure on wages—combined with a more accommodative Fed and a fourth factor, the historically strong performance of the market in the third year of a presidential election cycle—offsets, in our view, the clouds of slowing global growth and trade disputes that have hung over the market.
Volatility declined, most likely in response to the Fed. While the VIX was still relatively high when we rotated into high yield, thus dictating stronger than usual price strength signals before we were comfortable adding risk, it had already broken below 20, well off its December high of 36. A lower VIX tends to support prices, and we now feel even better about the trade into high yield as VIX settles into a range of 14-16, a level conducive to a sustained equity rally that would potentially support high yield as well.
We think many pensions and insurance companies bought Government bonds and in January thinking the rally suspect—which held the rate at about 2.7% on 10-year—rather than suggesting a higher risk of slower growth ahead. These investors are now taking on risk and should help maintain the strength of the risk-on trade. A 10-year yield well below 3% increases support for high yield. Last year the move over 3% adversely affected all risk assets, so we are encouraged that the yield premium is not ‘tight’ and can narrow as the economy maintains trend growth.

Finally, we believe purely technical indicators also support the risk-on decision. Stocks are still roughly 5% below their 2018 highs which translates to below average forward P/E ratios and, at year end, only about 1% of stocks were trading above their 50-day moving averages. When this market breadth gauge is less than 2%, the average gain in stocks over the subsequent 12 months has been about 25%.

Moreover, the recent rally in January has lifted 90% of stocks above their 50-day moving average. This development from negative status below the 50-day for most stocks to positive above their 50-day for 90% of issues, has happened only 9 times since 2000. The average gain 100-days after the change to above the 50-day moving average has been about 10%.

Our proprietary weekly price oscillator has been in negative territory. The move into positive mode took time, but we noted that the upside has t potential and was another factor in our model to ‘filter’ out potential drawdown because a sustained rally on a strong buy allocation had long-term potential for multi-month gains—assuming the buy on strength took place. So far, since the 2/1/19 buy allocation, the move into high yield has been positive.

With the trade-war rhetoric and a Fed that seemed to be having difficulty finding its way, the fourth quarter of 2018 was what we characterize as an event-driven market—where participants react and often overreact, to daily headlines—as opposed to the trend-driven markets when our approach seeks to shine by identifying medium- and long-term developments like bull runs and recessions early on. We were pleased in late January when our models began pointing to the emergence of a positive trend for risk assets that ultimately precipitated a move into high yield.

While we will continue to monitor and manage any daily events that arise, we will also keep a close eye out for the next important trend. With our conservative approach to volatility, we hope to avoid major drawdowns such as 2008—at such times high yield can decline 20-40% or more—while also seeking out potential gains that can follow major credit events. Those gains can be substantial: 20-40% or more upside after credit events and monetary tightening have done damage in the economic cycle. The goal of a long-term conservative approach, with risk filters in place, is avoidance of downside risk and capture of upside potential.

This commentary has been prepared for informational purposes only and should not be construed as an offer to sell or the solicitation to buy securities or adopt any investment strategy, nor shall this commentary constitute the rendering of personalized investment advice for compensation by BTS Asset Management. This commentary contains views and opinions which may not come to pass. To the extent this material constitutes an opinion or assumption recipients should not construe it as a substitute for the exercise of independent judgment. This material has been prepared from information believed to be reliable, but BTS Asset Management, Inc. makes no representations as to its accuracy or reliability. The views and opinions expressed herein are subject to change without notice.

It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. There is no guarantee that the strategies discussed will succeed in all market conditions or are appropriate for every investor. Investing in fixed income securities involves risks, including interest rate risk, credit risk, and reinvestment rate risk. Investing in lower quality bonds, known as high yield bonds, involves additional risks, including greater levels of default, credit and liquidity risks.

BTS Asset Management is affiliated with BTS Securities Corporation, member FINRA/SIPC. Securities are offered through BTS Securities Corporation and other FINRA member firms. Advisory services are offered through BTS Asset Management, Inc.

¹Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors' sentiments.
²For illustrative purposes only. This example does not suggest or imply that BTS’ models will achieve their investment objective in every market environment or always avoid losses. Investing involves substantial risk, including investing in BTS model portfolios.

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