Systematic Relative Strength

Markets are undergoing a lot of changes in traditional relationships right now. For example, Barron’s reports that corporates are the new Treasurys:

U.S. government debt is priced in the credit-default swap (CDS) market as having a higher-default risk than 22% of investment-grade corporate bonds. This means the CDS market, which influences the prices of corporate bonds, stocks, and the implied volatility of equity options, perceives Treasuries to be riskier than bonds issued by companies including Coca-Cola (ticker: KO), Oracle (ORCL) and Texas Instruments (TXN).

“This suggests corporates are the new sovereigns,” Thomas Lee, J.P. Morgan’s equity strategist, advised clients in a research note late last week, referring to corporate debt.

The phenomenon is also evident in Europe. J.P. Morgan’s Lee notes that 100% of corporate-debt issuers in Spain, Greece, and Portugal trade inside their government CDS spreads, while 60% of Italian corporate bonds trade inside that government’s spreads.

Historically, sovereign debt –bonds issued by governments – were considered low risk because governments can raise taxes or print money to pay their bills. During the credit crisis of 2007, governments all over the world printed money, and slashed interest rates to rescue the financial system, and are now saddled with massive debts. Now, some corporations might be financially healthier than governments.

There are also sharp changes in historical relationships going on in the commodity world, according to Reuters:

According to fund flows research company EPFR Global, commodity sector funds that invest in physical products, futures or the equities of commodity companies such as miners, attracted $1.465 billion in net inflows globally in the first two weeks of July.

The push into commodities in July reverses a trend in the second quarter, when investors pulled a net $3.9 billion out of commodities, according to Barclays Capital.

The move explains a divergence of stocks and commodities, with correlation dropping from more than 80 percent positive to around 40 percent negative over the past two weeks.

“Commodities could be seen in some ways as the least-worst option, given what is happening with other markets,” said Amrita Sen, an oil analyst at Barclays Capital who looks closely at fund allocations into commodities. “Some investors have not liquidated positions in commodities, while they have exited some other asset classes such as equities.”

All of the machinations with the debt ceiling and the associated market dislocations have posed a number of important questions for investors.

Q1) What happens to traditional asset allocations when traditional relationships break down?

Q2) How can we tell if the dislocations are a result of temporary factors or represent a permanent paradigm shift?

No one has all of the answers, least of all me, but a couple of things occur to me.

A1) The same thing that always happens when these ephemeral relationships change—your allocation doesn’t behave anything like you thought it would. Although the current uncertainties have highlighted the issues above, this kind of thing happens all the time. In the current investment hierarchy, debt is seen as safer than equity because it is higher up in the capital structure—but that’s only true for a corporate balance sheet. Sovereign debt always depends on the willingness of the sovereign to repay it. Anyone who is old enough to be familiar with the term “Brady Bonds” knows what I am talking about. If 100% of the corporate debt issuers in Spain trade inside the government debt spread, it’s not inconceivable for the same thing to happen in the US. In other words, there’s no a priori reason for government debt to be safer than other debt.

What about commodities then? Strategic asset allocation usually treats them like poor cousins, giving them a small seat at the children’s table. What if they really are the “least worst option” and deserve a major slice of the portfolio due to their performance? After all, commodities are at least tangible and do not rely on the willingness of a sovereign to be worth something. What if the correct safety hierarchy is a) high-grade corporate debt, b) equity in companies with growing revenues, earnings, and dividends, c) commodities, and d) sovereign debt, especially in countries with a ton of obligations and a sketchy political process?

A2) We can’t. That’s one of the issues with a paradigm shift—at the beginning, you can’t tell if it is temporary or permanent. Around 1900, it looked like the US might supplant the UK as the world’s industrial power. That turned out to be lasting. Around 1990, it looked like Japan might supplant the US as the world’s industrial power. That turned out to be temporary. Around 2010, it looked like China might supplant the US as the world’s industrial power—and we have no idea right now if that is a temporary conceit or will become a permanent feature of the landscape.

Constantly changing relationships along with an inability to distinguish between a temporary and a permanent state of affairs, to me, argues strongly in favor of tactical asset allocation. It simply makes sense to go where the returns are (or where the values exist, depending on your orientation). Money always goes where it is treated best, and if you wish to win the battle for investment survival, you would be well-advised to do the same thing.