Key Learnings from the Last QE Bond-Buying Program

Many executives have asked questions about how the rules changed in 2008, after the quantitative easing (QE) and government bond buying. While cause and effect are difficult to quantify, as we sit here in May 2020, the undeniable feeling is that we have seen this movie before.

During March 2020, we entered a QE and government bond buying program that puts the 2008 stimulus to shame. What were the unintended consequences last time? Can we use our knowledge from 2008 to offer any wisdom for today?

In 2015, Ed Easterling wrote about catalysts and conditions within his paper titled, “Exit from Wonderland: Change is Now on the Horizon.” Consider this…

CATALYSTS & CONDITIONS Catalysts are fuses; they represent sparks that ignite unstable situations. Conditions are the fuels that lie vulnerable to ignition. Catalysts may give rise to an event, while the conditions determine what if anything, happens next. In a typical secular bear environment, investors will find that the more actively managed and skill-based strategies tend to outperform the more passively managed and market-exposed strategies. Not only can skill and value find opportunity, but passive market-based returns—across full cycles—are extremely limited in secular bears. Nonetheless, the skill-based and value-oriented investments that are generally successful in naturally functioning markets have been distorted in recent years. With good intentions, the Fed and the federal government (“D.C.”) have imposed policies and programs in 2008/2009 that have led to misalignments and complacency in the markets and in the economy. ZIRP is the artificial suppression of short-term interest rates to zero or near-zero percent. Its goals have been to stimulate the economy by lowering the cost of borrowed money and to motivate investors to allocate capital to the stock market in order to promote a wealth effect that drives economic growth. Regardless of whether ZIRP has achieved its laudable goals, it has intentionally distorted market relationships. Distorted markets alter the effectiveness of skill-based and value-oriented investment strategies. This occurs because such strategies rely upon the ability of managers to identify and select undervalued and overvalued investments. When markets experience dislocated or manipulated relationships, skill acts as though it is executing in Alice’s Wonderland. Around the same time that the Fed started ZIRP, they initiated a series of bond-buying programs known as quantitative easing (QE). The purposes of QE have been to lower longer-term interest rates, provide liquidity to the financial markets, and promote higher stock prices. Like ZIRP, QE intentionally distorts the markets for laudable purposes. After accumulating $4.5 trillion in assets, the Fed ceased QE in October 2014. Although reversing and ending the distortive programs may initially roil the financial markets, the result should be to restore market relationships, thereby leading to more naturally functioning conditions. The resulting investment environment should be much more favorable for skill-based and value-oriented strategies.

So, In February 2020 the overvalued, overbought, overextended “condition” of US Equities made it fragile to a “catalyst” like the Covid-19 Pandemic. These Conditions and this Catalyst have led to unprecedented stimulus which can eliminate the opportunity for active skill based and value-oriented managers to outperform, if history is any guide.

At Pulliam Family Office we believe, what you Count, Counts. Active separately managed accounts and actively managed mutual funds would be exceedingly difficult for me to invest in knowing the recent history since 2008. I find a more compelling solution to be one that is rules based that demonstrated performance alpha since 2008. I am not lobbying for strategy or tactics that anticipates catalysts or conditions, I only want strategies that reveal simple solutions and alerts to change.

Consider one such switching strategy between 2 US Equity benchmarks: S&P 500 Cap Weighted Index vs The S&P 500 Equal Weight Index: 

One of the most storied relative strength relationships featured in Dorsey Wright research is the S&P 500 Cap Weight Benchmark versus S&P 500 Equal-Weight Benchmark matchup. Running a relative strength switching strategy between the two to determine which S&P 500 Index you want to model your investment after.

• From 12/31/1994 – 3/2/2020, Equally Weighted has been favored over Cap Weighted on a relative strength basis for about 77% of the time.
• In 30 years, only one change failed to produce outperformance in the switching strategy, which also happened to be the shortest-lived alert from 10/23/2008 – 4/16/2009, speaking to the adaptive nature of relative strength. 
• On a cumulative basis, Equally Weighted has outperformed the Cap Weighted by over 117%; however, if you employed a switching strategy, you could have greatly improved performance over buying and holding either S&P 500 Index as the strategy is up 822.24% since 12/31/1994 (see graphic below). 
• The Equally Weighted vs Cap Weighted moved to Risk Off on March 2nd, knocking the Equally Weighted Index out of the leadership spot for the first time since April 2009. Since that time, the Equally Weighted Index provided a +21% margin of outperformance over the Cap Weighted Index.
• Since the Cap Weighted Index moved to display positive RS against Equally Weighted Index just over a month ago, the fund has outperformed the Equally Weighted Index by over 500 basis points.

Source: Nasdaq Dorsey Wright

There is a compelling thesis to expect this recent catalyst that set off conditions to distort Global Risk assets for the short to intermediate term. If history is any guide, active managers will find this next trend to be particularly challenging to provide net outperformance after taxes and after fees. Simple Rules Based strategies can offer a better solution to the skilled based and value-oriented asset managers.

The Context of the Market is changing, how will you adapt? Consider how you should incorporate a Core Model, a Sector Rotating Model, a Cap & Style Model, a Tactical bond model. Ask me how we design, execute, and maintain these models for executives and their families like yours.

To create a disciplined approach to your asset management, schedule an appointment. To learn more about Nasdaq Dorsey Wright, click here.