2 Bubbles or not 2 Bubbles, That is the Question

Based on the below headline from today’s (5/8/13) WSJ below, I decided to run a comparison on SP500 vs Hedge Fund Indices for 2 time periods.  Period1 – Jan 2003 to Sep 2007.  Period 2 – March 2009 to end of April 2013.    As you can see from the image below, these were periods of outsized returns.


I used the S&P500 index rather than the DJIA as it gives a broader market picture.  I also compared the S&P500 to two hedge fund indices – the HFRX Global and Dow Jones Credit Suisse Broad Index.

First, let’s look at period1 by viewing Growth of a $1:


Now, Period 2


Now, let’s combine periods on the same graph:


So, what does this tell me:

1) S&P500 looking a bit overheated in comparison to the run-up of 2003 – 2007 (updated 5/14/2013).  I’ve seen the “this time is different” chatter, but even “different” markets follow “laws of gravity”.

2) In relation to Hedge Funds, 2003 to 2007 looks like a long leverage bet on equities.  Data confirms this.  A Period1 times series analysis of S&P500 vs HRFX Global Hedge Fund Index transformed for stationarity shows a correlation of .74.  The same time series analysis transformed for stationarity on Period2 index data has only a .01 correlation.

3) In terms of an uncorrelated return to equities, at a macro-level, hedge funds have delivered.

This is just a quick “back of the spreadsheet” analysis.  It would be interesting to include bond and commodity indices in the mix here.


Measuring the Risk in Risk Parity

Risk-Parity investment strategies focus on greater allocation to less risky investment to achieve a given return goal.  Leverage is used to “supercharge” the investment in the least risky asset class.  Conceptually, a great plan.

In practice, most risk-parity strategies use a long bond strategy.  Levering up long bonds via the use of futures and derivatives.  During the 10-year bond bull market and over the past 5-years with easy money, this has been a great tactic and led to excess returns.

The question for risk-parity investors is does this strategy hold going forward?  One school of thought says that coordinated Central Bank cheap money has inflated prices to artificial levels for both bonds and stocks.  Others say that while the bond market has peaked, the equity and commodity markets still have legs to climb higher.  No one really knows.  However, there are some factors that should lead risk parity investors to delve further into exposure analysis.  The main factor is that risk parity strategies have never been tested in a bear market for bonds.

To this end, I would recommend a r-Dex analysis of any risk-parity strategy.  Never heard of r-Dex?  r-Dex or Risk Downside Exposure is similar to Value@Risk in that it measures downside risk to the expected value of a portfolio.  r-Dex measures this risk by stress-testing the “left tail” of portfolio returns.  The value of r-Dex is that it allows you to test for highly-correlated negative movements across all asset classes (dependent testing) or simulate a “break” in a single asset class (independent testing).


Tail testing with r-Dex


From a risk-parity standpoint,  r-Dex would allow you to simulate risk of a simultaneous break in both equity, bond, and commodity markets.  Given that almost everyone agrees that the bond market has minimal upside potential, at a minimum, a r-Dex Independent test could be run only on fixed income assets.

Either way, using r-Dex would allow you to evaluate the Risk in Risk Parity.