1. 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

2. The S&P 500 is overvalued according to long-term valuation measures
Shiller CAPE is now at 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

3. 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

4. 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

5. 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
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6. 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!

7. 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)
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8. 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
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