We use an credit-equity relative value model in our tactical asset allocation strategy. This relative value model compares the recent trading relationship between the S&P 500 stock index and the Capital Context Corporate Index (C3I). The output of the model is a ‘fair’ value for the S&P given the current value of the C3I. If the fair value is above the current market level, then stocks are judged to be ‘cheap.’ If the fair value is below the market level, then stocks are judged to be expensive.
Indicators for the S&P 500 and other indices are available on our Index Indicators page.
The gauge we display on our homepage (and update daily) provides two pieces of information. First, the black arrow indicates how expensive or cheap the S&P 500 is deemed to be relative to our credit index. If the arrow is pointing in the red zone, stocks are expensive. In the green zone, stocks are cheap relative to high yield bonds.
This relative value leads to the next piece of information, the Equity Strategy caption. If stocks are cheap, then our TAA strategy leads us to go long stocks (that is, take on beta exposure). If stocks are expensive, then we prefer to be market neutral. In our TAA paper, we discuss using Treasuries to eliminate one’s beta exposure. We also find it profitable to use the strategy within the context of a 60/40 portfolio. If stocks are expensive, we recommend overweighting low-beta components. If stocks are cheap, we recommend taking on high-beta exposure. The performance chart above shows holding 60% SPY / 40% AGG vs. switching between 60/40 SPY/AGG and 40/60 SPY/AGG depending on the stock indicator.
The stock indicator tends to stick with expensive or cheap for long periods (weeks) of time punctuated by short periods of fluctuation. It performs best during down markets and sideways markets, when the credit-equity signal is strongest (as do our other credit-equity relative value models). In the context of TAA, this approaches a tautology, since hedging stocks during down markets will always produce better results than staying long (and vice versa for up markets). However, our research has shown that, over time, the hedging strategy reduces portfolio volatility without sacrificing portfolio return. Still, one’s commitment to the strategy must be measured in years rather than days since the strategy proves itself across business cycles.
As always, please read our Disclaimer before making investment decisions.