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

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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.

 

 

 

 

 

It’s Always All Macro

OK so maybe saying it is always “all” macro is a bit of an exaggeration but barely.

Looking at the average correlation of the stocks within the SP100 to the index itself we can see in the chart below that on a 63-Day rolling basis the correlation is at 44% which is the lowest it has been in over a year. Most traders know that the market accounts for some of an individual stocks movement. The reality is that over time macro has taken over more and more to the point where current data shows that 44% of a stocks movement is due to the overall market, and more often than not it is over 50%. So unless you are dealing in truly “special situation” stocks, and most of you are not, the market and consequently macro matters.

Rolling 3-Month Correlation Between SP100 and constituents.

Rolling 3-Month Correlation Between SP100 and constituents.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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

 

Some Characteristics of Share Buybacks-Or Why Volume Is Drying Up

Lately we have been doing some research into stock buybacks and have come to a few conclusions.

-Probably the most significant finding is that share buybacks, using data on the Russell 3000 universe, have resulted in almost $3 Trillion in shares disappearing from the market. Want to know why we have declining trading volumes over the past several years with NYSE average total volumes dropping -52%? The first culprit is not HFT but instead the great shrinkage in shares outstanding. (Click on chart to enlarge)

NYSE Total Volume

-Between companies buying back their shares, private equity taking companies private, as well as natural selection (at least where the government allows it) and you have several reasons why trading volumes are lower. There is less trading volume because there is less to trade.

-Sadly one aspect of share buybacks that didn’t really come as a surprise was how poorly companies are at valuing their shares. Warren B has said in the past that buying back shares can be a good thing as long as you are not overpaying. Well based on this it is safe to say that corporate America is indeed no Warren B. Management apparently found their companies woefully undervalued at the top in 2007 as they repurchased record amounts of stock and then woefully overvalued at the bottom in 2008. (Click on chart to enlarge)

R3K by month by sector

-It would seem as though many executives have a hard time figuring out how to spend their cash or the debt that they have raised. Instead of investing in their businesses they have decided to just raise the earnings per share by taking shares out of the market. If they were doing it when their stock was cheap it would be a good thing but instead it points, at least to us, as a lack of ideas for real growth.

-Another interesting though maybe not completely surprising thing we found is that the buyback phenomenon is entirely a large-cap thing. When we pulled data for the Dow Industrial’s we found that those 30 companies accounted for 44% of all $3 Trillion that we saw in the Russell 3000. (Click on chart to enlarge)

DJI Buyback by month by sector

-Breaking it down a bit further we found that if you take the top 50 companies by capitalization in the Russell 3000 they account for 52% of all buybacks. The smallest of the top 50 is Northrup Grumman which is a $15.8 Billion dollar company. While some smaller companies do indeed buyback their shares it is largely a large-cap thing.

-Another interesting thing we are looking at is where the buybacks are occurring. Breaking down the cumulative buybacks by sector we can see that technology and financials have seen the majority of the benefits while utilities, telecom, and materials have seen almost none of it. (Click on chart to enlarge)

Russell 3000 Cumulative Buybacks by Sector

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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

This Is The SP500. This Is The SP500 On Crack

Remember the anti-drug commercials with the frying pan and the egg? As of late it would appear as though investors have forgotten that you are supposed to say NO to drugs, especially during market hours. In the chart below we have a rolling 21-Day Standard Deviation for the SP500 as well as the 50-Day moving average of that number. On a one month basis we are at the second highest reading in over 10 years, second only to the crash of 2008. Looking at the smoothed 50-day moving average we are actually at a new high. The close to close movement is running at an average of 2.34%. (Click on chart to enlarge)

SP500 Rolling 21-Day Standard Deviation

How can you use this information? There are a few trading strategies you can investigate from this such as selling options or putting on some arbitrage positions betting the spreads will come back in. For most investors however the more important thing to see here is that risk management is not only paramount to your investing/trading but it is a moving target. As a general rule when volatility is high, or extremely high as the case may be, you would want to look at using relatively loose stops, scaling down your position sizes, lowering your leverage, raising cash, etc. While most, maybe all, long time traders already use good risk management we have found that far to many new traders don’t adjust their trading when the market gets stoned. Consequently they lose far more money then they have too. Following tools like this can help you to smooth out your returns and stay in the game.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We always use risk management and own the domain name riskfreak.com.

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