1. PREDICTING FUTURE EQUITY MARKET VOLATILITY ARE HIGH YIELD SPREADS A CANARY IN THE COAL MINE OR SIMPLY NOISE? ANDREW FISHER

2. DO HIGH YIELD SPREADS ACCURATELY PREDICT FUTURE EQUITY MARKET VOLATILITY?  Recent market commentary by a variety of market experts has emphasized the risks of recession indicated by widening high yield spreads  As the old market adage goes; when equity and bond markets disagree, trust the bond market  A more important consideration to market participants is whether spread widening actually predict periods of equity market volatility or drawdowns?  So goes another famous saying; the equity market has predicted ten out of the last three recessions  Which is accurate? The answer is key for asset allocation decisions

3. COMPARISON OF THE HY & EQUITY MARKETS Significant spread widening in the HY market appears to lead the S&P 500 But, spreads can be volatile – can they be used to time investments in the equity market? Weekly data for the Barclays high yield bond index goes back to 1998 – our test will incorporate data from August 1998 – Dec. 2015

4. TESTING THE DATA  Common indicators will be used to systematically determine when HY markets indicate when to be “risk on” and “risk off”  I will use weekly data to eliminate day to day volatility and avoid overtrading  Time frames chosen will be based off of common daily indicators  50 day is ~ 10 weeks  100 day is ~ 20 weeks  200 day is ~ 40 weeks  Indicators to test:  Moving average vs. price: 10wk, 20wk, 40wk  Moving average crossovers: 10wk/20wk and 10wk/40wk  Momentum: 10, 20, and 40 week rate of change* * Rate of Change (ROC) at time T calculated as T / T – N weeks where N would be either 10, 20, or 40 weeks.

5. TESTING THE DATA (CONTINUED)  Tests will examine both weekly volatility and equity market returns  Indicators will be updated using closing prices at the end of each week.  Test will be one week forward –  Return & volatility will be calculated for the following week  A positive indicator means “risk on” for the following week  Average and median weekly returns will be segregated based on whether the prior week was “risk on” or “risk off”  Tests will include the use of both a HY Spread indicator and an SPY indicator to control for results  If spreads do provide insight into equity market returns, they should perform as well or better than equity markets, otherwise investors would be better off relying on the equity markets

6. HY MARKETS – “RISK ON” & “RISK OFF” EXAMPLES Risk off Risk on Risk offRisk onRisk off

7. RESULTS ARE MIXED SPREADS PREDICT VOLATILITY BUT NOT LOW EQUITY RETURNS High Yield index represented by the Barclays High Yield Corporate Index. For crossovers with 1 week designated (i.e. “10wk”), the cross over is simply current spread vs. a 10 week moving average. “10wk/20wk” would represent a dual moving average cross over and “Mom” designates a Rate of Change calculation; i.e. t/ t-10week. “Risk on” periods represent periods where the shorter MA or spread is above the longer MA or when the ROC is positive. 10 wk, 20 wk, 40 wk were chosen because they correspond to common 50 day, 100 day, and 200 day MA’s. Results Weekly volatility is higher and avg. returns are lower when spreads indicate caution However, median returns are generally higher when spreads indicate caution 1 Test: weekly S&P 500 returns (SPY) when HY spread indicators indicate “risk-on” or “risk-off”

8. DO SPREADS IMPROVE RESULTS OVER SIMILAR EQUITY MARKET INDICATOR? Test: weekly S&P 500 returns (SPY) when the same SPY indicators indicate “risk-on” or “risk- off” Results again are mixed Similar equity indicators appear to forecast lower volatility but may not forecast lower average returns Do spreads provide additional insight into potential equity market risks?

9. HY SPREADS MAY PROVIDE GREATER INSIGHT INTO DOWNSIDE RISKS TO THE EQUITY MARKET High Yield index represented by the Barclays High Yield Corporate Index. For crossovers with 1 week designated (i.e. “10wk”), the cross over is simply current spread vs. a 10 week moving average. “10wk/20wk” would represent a dual moving average cross over and “Mom” designates a Rate of Change calculation; i.e. t/ t-10week. “Risk on” periods represent periods where the shorter MA or spread is above the longer MA or when the ROC is positive. 10 wk, 20 wk, 40 wk were chosen because they correspond to common 50 day, 100 day, and 200 day MA’s. Results When HY Spreads indicate “risk on”, measures of downside risk such as skew and semi (or downside) deviation are lower 1 Equity investors, particularly those that use put selling to increase income should also be considered with downside volatility

10. HY SPREADS MAY PROVIDE GREATER INSIGHT INTO DOWNSIDE RISKS (CONTINUED) High Yield index represented by the Barclays High Yield Corporate Index. For crossovers with 1 week designated (i.e. “10wk”), the cross over is simply current spread vs. a 10 week moving average. “10wk/20wk” would represent a dual moving average cross over and “Mom” designates a Rate of Change calculation; i.e. t/ t-10week. “Risk on” periods represent periods where the shorter MA or spread is above the longer MA or when the ROC is positive. 10 wk, 20 wk, 40 wk were chosen because they correspond to common 50 day, 100 day, and 200 day MA’s. Results When HY Spreads indicate periods of risk aversion, skew tends to be worse, indicating greater risk of drawdowns Downside (or semi) deviation, however, is lower 1 Equity investors, particularly those that use put selling to increase income should also be considered with downside volatility

11. BUT, CAN SPREADS HELP TIME THE MARKET? YES: SPREADS MAY IMPROVE SHARPE RATIOS Results In most cases, a global tactical asset allocation (GTAA) strategy that makes investments using spreads can improve annualized returns, lower volatility, and lower maximum drawdown over a passive investment in the S&P 500 Test: Invest in SPY if spreads indicate “risk on” and move to Treasuries when “risk off” Investments are made at market close each Friday and reevaluated each week Period tested is April 1 st, 1999 – December 31 st, 2015 GTAA strategy will be long the S&P 500, via SPY ETF, when high yield spreads indicate a positve "risk on" environment. When high yield spreads show caution is warranted (i.e. "risk off"), this strategy will close S&P 500 exposure and invest in 13 mo. T-Bills or long duration Treasuries, via TLT ETF. This backtest ignores taxes, transaction costs, and slippage and assumes all trades are transacted at each Friday's closing price, when each week ends.

12. DO SPREADS BEAT THE SAME EQUITY INDICATORS? SOMETIMES, BUT NOT ALWAYS See prior page for details on GTAA strategy

13. ALL INDICATORS OUTPERFORM PASSIVE EQUITIES BY AVOIDING LARGE DRAWDOWNS Strategies selected for example purposes. Results exclude taxes, slippage, and execution costs. Returns would be lower if these were to be included Annual returns between HY & equity indicator vary wildly The markets appear to price different risks at different times The strategies tend to underperform in bull markets The old adage: “Markets have predicted 10 of the last 3 recessions”

14. ALL INDICATORS OUTPERFORM PASSIVE EQUITIES BY AVOIDING LARGE DRAWDOWNS (CONT.) Strategies selected for example purposes. Results exclude taxes, slippage, and execution costs. Returns are would be lower if these were to be included

15. ARE RESULTS IMPROVED BY COMBINING HY SPREAD AND EQUITY INDICATORS?  Yearly returns fluctuate for both methodologies show significant fluctuations vs. a passive investment and as a result, may be discounting different risks  Incorporating both signals into an analysis allows us to leverage the knowledge of even more market participants (assuming equity and bond investors are relatively segregated)  Next test will combine equity & HY spread indicators (“dual signals”), selected based on results from prior tests

16. DUAL SIGNALS PROVIDE SIGNIFICANTLY MORE INSIGHT INTO EXPECTED EQUITY VOLATILITY When both signals are risk on: -Average and median returns are higher and downside risk are lower When both signals are risk off: -Average and median returns are lower and downside risk is higher Signals diverge ~25-30% of the time -Divergent signals still forecast relatively low volatility

17. ADDING DIVERGING SIGNALS TO THE “RISK ON” TEST PERIOD To avoid over-trading, we segregated returns into two categories: -Either signal risk on -Both signals risk off Results are still impressive and strategies would be in the market 75% of the time

18. COMPARING RESULTS: INVESTORS BETTER OFF USING BOTH SPREAD & EQUITY INDICATORS A GTAA strategy that invested only when both markets signaled strength, would be invested just 50% of the time, potentially limiting its effectiveness However, investors that engage in put selling could potentially avoid large drawdowns by timing put sales

19. GTAA STRATEGY COMPARISON HIGHER SHARPE RATIO BUT LOWER RETURNS Risk averse investors can improve Sharpe ratios and limit drawdowns Returns, however, are lower since you are invested in equities just 50% of the time

20. GTAA STRATEGY COMPARISON DUAL SIGNAL 1 RETURNS ARE GENERALLY LOWER The Dual signal 1 shown does not improve returns, but the more conservative dual signal (not shown) greatly improves risk-adjusted returns Equity / HY Spread Dual signal shown here invests in equities if either bond or equity markets are “risk on,” and moves to Treasuries only when both indicators are risk off. This strategy increases returns but lowers the Sharpe ratio over a dual signal that invests in equity markets only with bond and equity markets are signaling “risk on.” 1

21. COMPARING RETURNS BY YEAR A DUAL SIGNAL INVESTS IN EQUITIES LONGER Returns improved in bull markets at the expense of greater drawdowns Equity / HY Spread Dual signal shown here invests in equities if either bond or equity markets are “risk on,” and moves to Treasuries only when both indicators are risk off. This strategy increases returns but lowers the Sharpe ratio over a dual signal that invests in equity markets only with bond and equity markets are signaling “risk on.”

22. COMPARING RETURNS BY YEAR A DUAL SIGNAL INVESTS IN EQUITIES LONGER Returns improved in bull markets at the expense of greater drawdowns Equity / HY Spread Dual signal shown here invests in equities if either bond or equity markets are “risk on,” and moves to Treasuries only when both indicators are risk off. This strategy increases returns but lowers the Sharpe ratio over a dual signal that invests in equity markets only with bond and equity markets are signaling “risk on.”

23. CONCLUSION: HY SPREADS DO PROVIDE CLUES ABOUT FUTURE EQUITY MARKET VOLATILITY  High Yield spreads can indicate when equity markets are likely to enter periods of higher volatility and stress  Equity markets can also provide these same clues, but high yield spreads appear to turn first  For example, the 10wk / 20wk moving average crossover provided the following risk off signals  2011: June 3 (HY) vs. June 17 (SPY)  2008: July 17 (HY) vs. August 17 (SPY)  1999: July 23 (HY) vs. September 17 (SPY)  High Yield spreads also trigger false signals and result in over-trading  A moving average crossover system can somewhat limit these false signals  A combination of HY and equity indicators can also limit false signals

24. CONCLUSION: HIGH YIELD SPREADS DON’T ALWAYS FORECAST LOWER EQUITY RETURNS  Returns from the GTAA strategies are mixed. HY markets appear to lead equity markets in large downturns but they also lead to false signals.  Positive results for GTAA strategies may have been skewed by two large bear markets that may not repeat with the same regularity  A Fund manager could underperform for numerous years, resulting in client disappointment and loss of asset  Results are also mixed at different period lengths:  HY Spread: 20 week (100 day) moving average appears best  Equities: 40 week (200 day) moving average appears superior  Why? Possible explanations include  Volatility – High yield bonds are less volatile; a medium-term MA therefor generates more reliable signals  Data mining: Time period tested with no out of sample test  Without a clear explanation, I recommend sticking with one Moving Average time period  Further testing also warranted:  Long-term outperformance generated during recessions  Further tests should consider additional enhancements that incorporate Treasury yield curves or economic data

25. APPENDIX 1 HISTOGRAM OF WEEKLY EQUITY MARKET RETURNS During period tested, the S&P 500 had a positive price return 54% of the time At first glance, weekly S&P 500 returns follow a relatively normal distribution, but with fat tails Negative returns show significant skew Avoiding these drawdowns can significantly improve Sharpe ratios Average Loss of 13.5%

26. APPENDIX 2 HISTOGRAM OF RETURNS – DUAL INDICATOR When both markets signal, “risk on,” the S&P 500 has a positive price return 55% of the time, not that much better than average However, it limits drawdowns:  only 2 weeks had a negative return of 5% or more  compared with 22 weeks over the full sample period When both markets signal “risk off,” volatility is significantly higher, on the upside and downside The equity markets had a loss of more than 5% 17 times, out of only 209 weeks in our sample Surprising, 14 weeks saw gains of more than 5%

27. APPENDIX 3 HISTOGRAM OF NEGATIVE RETURNS A moving average crossover system that incorporates both bond and equity markets may help investors cut off left tail risks While results are mixed for GTAA strategies, other strategies may benefit from such a system More research is needed to determine if volatility markets accurate reflect these different regimes Average Loss of 13.5%

28. APPENDIX 4 COMPARISON VS. JUST HY SPREADS A dual indicator system also improves results over HY Spreads alone  9.3% of all weeks when both indicators were “risk on” resulted in a loss great than -3%  11% of all weeks when HY Spreads were “risk on” resulted in a loss greater than -3%

29. APPENDIX 4 COMPARISON VS. JUST HY SPREADS A dual indicator system also appears to catch more periods of significant drawdowns  35.0% of all weeks when both indicators were “risk off” resulted in a loss great than -3%  28.4% of all weeks when HY Spreads were “risk off” resulted in a loss greater than -3%