A Market Timing Strategy for Tail Risk Hedging Can the use of momentum and valuations improve a put option strategy? Andrew Fisher March 2014 UPDATED – January 2016

The S&P 500 is overvalued according to long-term valuation measures Shiller CAPE is now at 25.44 - 1 standard deviation above it’s long term average This level has only been reached 5 times in market history (including the current period) Tech bubble Roaring 20’s/ 1929 Stock market crash Financial crisis 1966 Bear market As of 28 March 2014 SOURCE: Yahoo Finance!, Shiller Website

Prior periods of extreme overvaluation have resulted in significant drawdowns Period mentioned Valuations measure market sentiment; i.e. investors expectations for future growth and returns When valuation/sentiment reach extreme levels, statistically significant market losses result Statistically significant: The length and size of corrections cannot be explained by random walk or normal distribution An investor that can avoid these “tail events” will significantly improve their long term returns Market peak Market low Months Peak to trough TSTAT P Value Sept 1929 Jun 1932 33 -85% 4.5 0.000 Feb 1966 Oct 1966 8 -24% 2.48 0.015 Sept 2000 Oct 2002 25 -50% 3.22 0.002 Oct 2007 Mar 2009 17 -58% 4.04 As of 28 March 2014 SOURCE: Yahoo Finance!, Shiller Website

Can long term valuations be used to implement opportunistic tail hedges? Unfortunately No – the market can stay irrational longer than you can stay solvent Fundamental measures of valuation show predictive power over the long term but have no predictive over the short term Measures of valuation cannot tell you when market sentiment will turn As of October 2012 SOURCE: Vanguard

Can other measures of stock market health provide clues about future performance? Momentum Momentum is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling Academic research has shown that momentum tends to dominate over short periods of time and reverse over longer periods of time in ways that cannot be explained by the random walk hypothesis and normal distribution A historical review of market momentum shows that markets routinely move between periods of euphoria and despondency Momentum Oscillators Oscillators measure the speed and change of stock price movements and may alert us to changes in investor sentiment While Momentum oscillators trend, they exhibit too much noise limiting their ability to predict extreme market movements Real rates and break-evens Nominal rates and break-evens Interest Rate Forecast: 2.2% on the 10-yr Treasury by year end, Bill Gross on Client Conference Call 7/1/2013 10-yr Treasury should be range bound throughout the remainder of the year between 2 – 2.5%, Tony Crescenzi on Client Conference Call Reasons for 2 – 2.5% range: Inflation is low. PCE is currently at the lowest its ever been Demand for safe assets is growing more derivatives are centrally cleared (BIS estimates $5T increase in demand) and require high quality collateral The universe of AAA safe assets has fallen with downgrades Treasury has also been reducing issuance in line with falling budget deficit Demographics will lead to more risk averse investors 44M Americans are 75 and older while 35M are between 55 and 64 Federal Reserve Even if the Fed cuts back on asset purchases, they are still buying a large amount By the end of this year, the Fed will own between 30-45% of all Treasuries past 3-years in maturity Demand – Natural buyers will maintain demand (insurance companies and foreign governments) Potential Peak for 10 year – 4%.  In 40 years, the 10-yr yield has never risen above 400bps above the Fed Funds target rate (currently 0%) Investor euphoria Investor despondency 4cs_TR_review_08a 4

Can a combination of fundamental valuation and momentum provide market timing insight? YES - Valuation measures market sentiment while momentum can alert us to shifts in sentiment It is not the periods of euphoria that are dangerous – it’s the shift in sentiment from extreme levels Roaring 20’s/ 1929 Stock market crash Investor euphoria Tech bubble Financial crisis 1966 Bear market Investor despondency However, these shifts in sentiment from extreme levels may create opportunities for nimble investors As of 28 March 2014 SOURCE: Yahoo Finance!

A systematic trading strategy using momentum implementing an opportunistic tail risk hedging program Market Indicators: What to watch Shiller CAPE > +1 standard deviation LT average LT momentum is overbought Market Timing: When to implement Open short positions (both must be true) 6MA of LT momentum oscillator falls below overbought levels Slope of 10 month prices turns negative* Close positions when: LT momentum indicator falls below 30 and then rises above its 3MA Caveat: If LT momentum falls back below 3MA before rising to 50, re-initiate short position Real rates and break-evens Nominal rates and break-evens Interest Rate Forecast: 2.2% on the 10-yr Treasury by year end, Bill Gross on Client Conference Call 7/1/2013 10-yr Treasury should be range bound throughout the remainder of the year between 2 – 2.5%, Tony Crescenzi on Client Conference Call Reasons for 2 – 2.5% range: Inflation is low. PCE is currently at the lowest its ever been Demand for safe assets is growing more derivatives are centrally cleared (BIS estimates $5T increase in demand) and require high quality collateral The universe of AAA safe assets has fallen with downgrades Treasury has also been reducing issuance in line with falling budget deficit Demographics will lead to more risk averse investors 44M Americans are 75 and older while 35M are between 55 and 64 Federal Reserve Even if the Fed cuts back on asset purchases, they are still buying a large amount By the end of this year, the Fed will own between 30-45% of all Treasuries past 3-years in maturity Demand – Natural buyers will maintain demand (insurance companies and foreign governments) Potential Peak for 10 year – 4%.  In 40 years, the 10-yr yield has never risen above 400bps above the Fed Funds target rate (currently 0%) As of 28 March 2014 SOURCE: Yahoo! Finance, PIMCO * Slope is defined as the coefficient generated by a linear regression of prices (rise over run) 4cs_TR_review_08a 6

Strategy Back-test: Results show strong potential as a hedge a long-only portfolio S&P 500 – Peak to Trough Market Performance Real rates and break-evens Nominal rates and break-evens Interest Rate Forecast: 2.2% on the 10-yr Treasury by year end, Bill Gross on Client Conference Call 7/1/2013 10-yr Treasury should be range bound throughout the remainder of the year between 2 – 2.5%, Tony Crescenzi on Client Conference Call Reasons for 2 – 2.5% range: Inflation is low. PCE is currently at the lowest its ever been Demand for safe assets is growing more derivatives are centrally cleared (BIS estimates $5T increase in demand) and require high quality collateral The universe of AAA safe assets has fallen with downgrades Treasury has also been reducing issuance in line with falling budget deficit Demographics will lead to more risk averse investors 44M Americans are 75 and older while 35M are between 55 and 64 Federal Reserve Even if the Fed cuts back on asset purchases, they are still buying a large amount By the end of this year, the Fed will own between 30-45% of all Treasuries past 3-years in maturity Demand – Natural buyers will maintain demand (insurance companies and foreign governments) Potential Peak for 10 year – 4%.  In 40 years, the 10-yr yield has never risen above 400bps above the Fed Funds target rate (currently 0%) Trading Strategy Back Test – Performance Conclusions of our back test It is impossible to perfectly time the market but we can capture the majority of extreme market moves The need to avoiding false signals limits profit potential but helps to avoid shorting a rising market As of 28 March 2014 UPDATED: 29 February 2016 SOURCE: Yahoo! Finance, PIMCO 4cs_TR_review_08a 7