If This Is A Recession I Will Run Down The Street Naked*

The asterisk is because obviously there will be a recession one day the trick is to have an idea of when it could start. For me to run down the street naked, something I haven’t done since high school, a recession has to start in the next six months.

Why all the confidence? Well aside from all these pundits coming out saying there is a 100% chance that we are in a recession or that a recession will start before summer the reason is that the data doesn’t show it. You can make up indicators that don’t really make sense either in their construction or their interpretations or you can focus on one relatively narrow segment of the economy but none of that actually means we are entering a recession.

If you want to gauge the probability of a recession it might be helpful to really study the business cycle and how we enter and exit recession as well as how we do not. You then want to build a battery of models to help you interpret what is happening and what is likely to happen going forward. If you do this, and don’t focus on just one indicator, you will be far better off than what most pundits do.

One thing to look at, and maybe the most studied indicator in the history of economic indicators, is the yield spread. You can use just about any of the common spreads like the 10-2, 10-Fed Funds, 30-Fed Funds, 20-Fed Funds, etc. Anything that is definitely towards the long end of the curve and the short end of the curve should do. By the way you can do all of this in Excel using the excellent FRED plugin from the St Louis Federal Reserve.

What does the yield spread tell us? Well in general terms it is a tool that helps us gauge how tight or loose liquidity is. If the Fed wants loose monetary conditions they usually lower the Fed Funds rate and if they want tighter conditions they usually raise the Fed Funds rate. You can see this clearly in the chart below of the 20-Year yield, the Fed Funds rate, and recessions.  When the Fed wants to slow the business cycle the red line moves higher as they raise rates and when they want to spur business on they lower Fed Funds and the red line drops. Look at where we are now.

20 Year Yield and Fed Funds Rate

20 Year Yield and Fed Funds Rate

If we look at the actual spread of these two yields it might help you see what we are pointing at. You take the 20-Year yield and subtract the Fed Funds yield to get the spread. When it is moving higher we are usually expanding and when it gets almost flat or even inverted we are usually close to a recession.  Right now the spread is narrowing but it is a long ways off from being flat let alone inverted.

Yield Spread

Yield Spread

So right now it should be obvious that the Fed, despite hiking rates back in December, is still allowing business to enjoy relatively loose monetary policy. Everything from the yield spread is saying that a recession is not very likely in the near term. Before we end this however lets look at what a probit model says about the position of the yield spread.

The chart below shows the odds of a recession based on a model from Jonathan Wright at the Fed. His paper “The Yield Curve and Predicting US Recessions” shows how he built this model and how it works. In the paper there are actually two models. Model 1 is decent but Model 2 has been more accurate. What is great is that you can use both of them and then try and figure out what the yield curve and the Fed really want. Model 1 currently is saying there is a 17.91% chance of a recession while Model 2 is saying that there is a 0.05% chance of a recession.  Even if we just take an average of the two we get down to a 8.98% chance of a recession which is a far cry from a 100% chance or even a 50% chance of a recession.

Yield Curve Probit Model

Yield Curve Probit Model

Now to be fair we use far more indicators and models than just the yield spread. But here is the thing…only manufacturing is giving any real signs of stress. Every other major group of indicators is showing neutral to positive readings. Check out housing, employment, or even wages and you will see that things are actually looking pretty good.

Go immerse yourself in the data and see for yourself. In the meantime I am betting on me NOT having to run down the street naked.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

Employment Leading or Lagging Indicator?

If you read much on the business cycle then you have probably heard that “employment is a lagging indicator”. We have read and heard it from the mouths of pundits on TV, economists on TV and in print, and in research reports.  But as with anything just because a lot of people say something doesn’t mean its true. The earth was only flat until someone tried it out and realized it was not.

The same goes for employment. If you use the most basic of employment indicators the headline unemployment rate and then match it up with recessions, easily done in Excel with the FRED plug-in (BTW I love FRED and you should too), then you can see that employment is not only NOT a lagging indicator but is not even a coincident indicator. If it doesn’t lag and it doesn’t coincide then what is left? Yes, it is a LEADING indicator. Crazy right? All those people on TV are wrong who would have guessed (read with a heavy dose of sarcasm)?

Here I took the unemployment rate and flipped it to become the employment rate. it is the same data but in a happier more optimistic format. It is overlaid on the NBER recession dates. If you look at it, and you don’t even have to look very closely, you will see that there is a very consistent pattern leading up to a recession. The rate starts to roll over. In the 50’s and 60’s it was barely a leading indicator but since then the lead has gotten longer and longer. How it was ever considered a lagging indicator is beyond me.

Percentage of Workforce That Is Employed

Percentage of Workforce That Is Employed

So what is this chart telling us, or indicating to us, right now? Well if you believe the post-WW2 period has any relevance to today, we obviously do, then it is saying that we are not in a recession and are not overly close to entering a recession.  Anything can happen and this indicator could be wrong this cycle but based on the data the odds are low.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

P.S.-before you send me a chart of the labor force participation rate let me say a few things. 1-I have seen it, have charted it, studied it, etc. so I know its declining and am not really worried 2-I would invite you to not just look at it and listen to a pundit but actually download the data, read about the data, compare it to other data, study demographics, and then if you still think I just NEED to see it feel free to send it my way.

Two Tales Of The Same Indicators

As of late we have been seeing the following chart pop up all over our Twitter feed as well as in our inbox.  You don’t even have to look very closely to see that over the past 20-Years the ISM Manufacturing Index and the year over year change in the SP500 have been highly correlated. This might lead you to believe that we are headed for a doom and gloom bear market and even a recession. After all an ISM reading below 50 indicates a contraction while readings above 50 indicate expansions.  With a reading of 48.2 we are obviously below 50.  So guaranteed recession right? Not so fast.

ISM and SP500 Last 20-Years

ISM and SP500 Last 20-Years

If you look at the above chart again, but closely this time, you can also see that not only does it only cover the time period from 1998-now but that there have been several reading below 50 that did not lead to a recession.  If we instead turn our eyes to the next chart of the 10-Year correlations of the ISM PMI and the SP500 YoY change we can see that it has only been in the past 10 years or so that the relationship was anything near what it is today. In fact right now the correlations are at an all-time high around 80%. Looking at past eras however show that sometimes the relationship has been at 40%, others in the 20% range, and still others displayed a negative correlation. Yes, this means that when the ISM index went negative, sub-50, the SP500 went positive.

ISM-10-Year-Correlations With SP500 YoY Change

ISM-10-Year-Correlations With SP500 YoY Change

If we look at the next chart of the ISM Index and the SP500 YoY, but this time all the way back to the beginning of the ISM data we can see how tenuous this relationship has been over time.  Not only has a sub-50 ISM number not been anything close to an automatic recession but it doesn’t even mean stocks have to go lower.

ISM and SP500 Full History

ISM and SP500 Full History

Now could stocks go lower and could we be in a recession?  Of course they could and of course we could. The point we are trying to make is that there are so many false positives that you can not overweight this indicator to much in your framework. In fact if we look over the history of the ISM, or just the history of the economy, we can see that manufacturing is actually less important to the economy than ever before and that this has been a long term trend as we have transitioned towards a service/knowledge based economy. We don’t make stuff if we can have China make our stuff cheaper.  In fact manufacturing currently only represents 12% of GDP and 8.6% of employment in the United States.  Seen in this light, and combined with the rest of our business cycle work, we do not see an imminent recession in the United States.

At the same time according to JP Morgan manufacturing does account for almost 60% of the profits in SP500 companies.  So while the odds of a recession are relatively low the odds of earnings being low and going lower are fairly high. This would not be the first time that we had a correction or even a bear market amidst an expansion.

Don’t overweight any indicator more than its history and causality deserves. Don’t mistake a mid-cycle correction with a recession or the end of the world.  Do take a holistic approach to the economy and look under as many rocks as you can while also figuring out what really moves what. Finally, at least for now, realize that as important as the stock market and the economy are, in the short run, they are not the same thing.  Trade accordingly.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

How To Lose All Your Money….Or At Least More Than You Should

Today was the most watched Fed Day in years…and that’s saying a lot since every Fed Day seems to be the most important ever. US rates tanked across the board while other markets mostly flew higher only to close lower.

In our model portfolio we gained a whopping 8 basis points. That is 0.08% for the day. It obviously would have been nice to have gotten everything right and make more but the flip side is that we REALLY don’t want to get everything wrong and lose a lot.

One of our goals over the years has been to get the portfolio to where no one event, at least not a normally scheduled event, poses much risk to us. If a nuke lands in a major city we could take a big hit. If an alien lands in DC who knows what would happen. But if the Fed has a scheduled meeting we should not be overly exposed to anything that has much of a chance of happening.

One way we are able to do this is by diversifying across asset classes. In fact one of the best things about macro trading is that you are kind of supposed to go across asset classed looking for great risk/reward situations. Being long and short across assets is one way to minimize event risk. Another way is to have trades on with different primary drivers such as growth, inflation, relative value, events, etc. Basically bet on a diverse set of risks across a diverse set of assets.

Why stop there however when you can then focus on price correlations, structuring your trades, sizing your trades, and the placing of stops?

All of this to say that if you want to eventually lose all of your money then make sure that you don’t do any of the above. Make sure that your entire portfolio is based on being completely right on one thing. To make it even more fun ensure that the one thing has a small chance of happening. Why bet it all on a Fed outcome when you can go all in, even levered, on a bet that the USD will collapse and our entire system will go back to the stone ages.

While some of that was said in jest….at least kind of, the reality is that many long term portfolios are setup to only do well in one economic condition and even more “trader” portfolios are betting on one or two outcomes on different events.  If you want to improve your risk adjusted, as well as your absolute, returns then pay attention to this stuff, think about it, study it, etc. and see what you can do to improve your risk and diversification processes.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

 

Some Thoughts On Market Timing Part-1

This is the first in a series on what timing is, what it isn’t, and some right ways to do it. 

In recent days I have been experimenting with one of our proprietary indicators to expand its use. I named this indicator a “Risk Index” with the idea being when the indicator is high the risk are low and when the indicator is low the risks are high. As you can see in the chart below a higher percentage reading indicates a more favorable market and a lower reading indicates a less favorable market.

US Equity Risk Index

US Equity Risk Index

Our risk index is simply the percentage of out timing models that are bullish or bearish each week. For US equities we run 10 different models that look at trend, valuation, interest rates, inflation, sentiment, breadth, and intermarket relationships. I estimate that 53% of the individual components in the 10 models are equity trend based. There are a few reasons for this but the most important gets at the heart of timing. We use timing tools to help us first lower risk and in a distant second to increase returns. It turns out that trend following indicators while not a “Holy Grail” do a great job at keeping you in the big moves and minimizing your downside.

Our models come from many places. If you are familiar with Nelson Freeburg, Marty Zweig, and Ned Davis you would recognize a few of the models and would be able to see the inspiration in the other models.* Five of the 10 are straight from their material and the other five while homegrown take inspiration from their work. All the models have been backtested and while most of them slightly improve returns they all drastically improve drawdowns which is our primary goal.

So if each of these models is solid in its own right why would we take a consensus approach? There are several reasons but the two that stand out are that you never know when the market is going to change and invalidate a model. Now we can stand a prolonged period of under-performance but we cant handle a catastrophe.  If a model underperforms for a long enough period of time we would take it out if we could see that something had changed. As an example I once created a breadth based system that I was able to backtest and it generated low 20% returns with the worst drawdown being just over -7%. Well I got to use it for about a year before decimalization came and within weeks the results when to hell. I suspected something was off but it took a few more months to confirm it. I still update it and monitor it as it displays a certain segment of market behavior but its risk/reward is no longer favorable.

Of course most of the models in the risk index are based on weekly data and are longer term in nature. Still the risk is very real that something changes and some of them cease to be useful. By taking a consensus approach any downturn based on a degrading model can be minimized.

We are not going to get into the specifics of each model but instead how almost any model, in this case a consensus model, can be used. Don’t worry because in a future post we will go over how to build a simple but effective long term timing model.

So we have a US Equity model that is based on the buy/sell signals of 10 separate timing models. How can we use it? We could backtest it and see what readings give the best risk/reward and trade it that way but what inspired this post was the idea that we would just invest X% of a portfolio depending on the reading. If the model said that 50% of the models were on buy signals we would invest 50% of the portfolio and change it each time the buy signals percentage changed.  If that went well, it did, and sufficiently cut risk, it did, we could then experiment with different levels of leverage.

We did this with the data we had on hand and got the following results. Trading SPY-SP500 ETF, and using the total return series so that includes dividends, we got the following results. Buy and hold did fine on the upside but had a -50.77% drawdown. Timing trailed a bit on the upside but only suffered a -13.67% max drawdown. Finally by using a full 2X leverage we were able to cut buy and hold risk in half and increase returns by 1.89 times. In case you are wondering by using only 1.2X leverage you beat buy and hold by a few bucks but your max drawdown is still under -15%.

Risk Index SPY Returns and Drawdowns

Risk Index SPY Returns and Drawdowns

Looking at a chart of the equity curves for each of the strategies you can see how timing plus leverage killed buy and hold. Of course while max drawdown was far less the intermittent drawdowns were sometimes larger. Take 2011 for example when the market corrected just enough to turn the model down to 10% bullish only to rocket higher. That is the main risk to any system as you can get whipsawed in and out during a longer term trend. Of course anytime you are using leverage you can expect to have higher volatility at times as you are seeking higher returns.

Risk Index Equity Curves

Risk Index Equity Curves

Looking at the individual drawdown charts shows just how risky buy and hold is as the SPy-SP500 ETF was down over -50%. This of course requires a 100% return just to get back to breakeven.

Buy and Hold Drawdowns

Buy and Hold Drawdowns

Looking at the drawdowns for the timing without leverage equity curve you can see that while it has a lot of little drawdowns it has only had three double digit drawdowns since early 2008 with the worst one being -13.67%. It may have lagged in total return but not by much and as such would have been a lot easier to handle. Of course as we discussed one would only need 1.2X leverage to achieve equal returns with buy and hold with less than 1/3 the risk.

Timing Drawdowns

Timing Drawdowns

Finally we have the drawdown chart of the timing strategy but using 2X leverage. As you can see the worst drawdown was half of that of buy and hold. Of course the next two worst drawdowns also hit -20% in contrast to buy and hold which only had one more -20% drawdown. Still the overall risk has been cut in half and the returns almost doubled.

Timing Plus Leverage Drawdowns

Timing Plus Leverage Drawdowns

 

Why do we only have the risk index back to 4/11/08? We are working on extending it back a few decades but as we were building these we had some data limitations on two of our homegrown models. When we finish building them out we will share the results with our subscribers as well as the blog.  For now however we think that capturing most of the carnage of 2008 along with the correction of 2011 does a decent job of what can be accomplished with a good timing model and a few different ways to use it.

One aspect of this model that we like is that is gives a specific allocation percentage instead of just a buy/sell signal. This will be the purpose of a future post but if you go back and read all the Marty Zweig stuff, and Zweig was a timer if there ever was one, he never said to go all in or all out.

“How should you, the reader of this book, react to the constantly changing circumstances? Basically, I think you should shun the idea of buy-and-hold. I consider it a fallacious strategy. In the coming decade we are likely to see more bear markets and deeper ones. To lower risk, there will be periods when you should peel back your investments, in the stock and bond markets. It’s a matter of degree. You don’t have to go 100% to cash but you should cut back as risk rises and invest as risk recedes. I believe my market-timing methods in this book will help you do just that.”Marty Zweig from “Winning On Wall Street”

If you go read Howard Marks book “The Most Important Thing” you will find variations of the same concept. If you are a traditional value guy/gal your heart just skipped a beat as I said Howard Marks in the same post as “market timing”. The reality is that all active management has the same goal-minimize risk and maximize reward. Marks in his excellent book talks about assessing the range of future outcomes and  discusses risk throughout both his book and other writings. Despite different approaches both Marks and Zweig have the same goal. be aggressive when their indicators-be they book values or how much the ZUPI moved-say to be aggressive and back off when things look risky.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

*I can’t write this and not give credit where credit is due. Nelson Freeburg the late publisher of Formula Research was a fantastic guy and his publication as well as correspondence has had a great influence on me. In fact while the idea of combining timing models together was not new, the way in which he did it elevated my thinking to a new level in his January 15, 1998 issue “The Power of a Composite Stock Market Model”. The components of my risk index are very different but if you read that report you can not help but see similarities.  Aside from that report however he put out more interesting and functional models than anyone I know of. If you can get a hold of any, or all, of them you will be better for it.