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

 

Some Benefits Of Trading Across Asset Classes-Or An Advertisement For Global Macro

With only a few weeks left in 2015 it would be a fair statement to say that there has been a lot of troubles in the asset management business. US Stocks are flat, bonds are flat, foreign stocks are down, commodities are down, junk bonds are down, and gold is down.  Here is a year to date performance chart of some of the major asset classes.  As you can see it has been less than ideal for the long only world.

Asset Classes

Some Major Asset Classes YTD

Years like this are why we are such big fans of being able to go long/short across asset classes.  In our model portfolio equities have been a drag in 2015 of a bit over -4.00%. We were short emerging market stocks for part of their fall but aside from that we mainly lost money on our equity trades.  Fixed income added slightly less than +1.00%. Being short commodities off and on, gold and copper, has added around +5%. This year currencies have been our big winner adding over +13.00%. As of last night our model portfolio is up 15.60%. Our worst drawdown on the year was -5.35% and we are currently down -1.83 from our equity highs.

TheMacroTrader.com Model Portfolio Equity Curve 2015

TheMacroTrader.com Model Portfolio Equity Curve 2015

If we had a fixed mandate of being only long equities, long fixed income. or long anything we would have been flat at best and probably negative for the year. Instead we had the flexibility to go where we found the best risk/reward opportunities.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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

 

 

 

 

Macro Is Dead, Long Live Macro

If you read the popular financial press you may be led to believe that because a few macro funds have closed down this year, a few legendary traders have closed their funds over the past few years, and because global macro as a category has done poorly post-crisis that macro is dead.  If we have learned anything post-DotCOM bubble it is that when a strategy has died it is really just coming back to life.

Let’s address the above reasons for macro’s supposed death. The first is that a few prominent funds have closed this year. Everest, COMAC, and Fortress have or are closing their doors. They all got hit hard when the Swiss National Bank blew their EUR/CHF peg earlier this year. Everest basically blew up, COMAC decided to turn into a family office, and Fortress kept fighting the fight in public until announcing a few weeks ago that it is closing up its macro business. Here is the thing though, of the three only one lost “all” their money. COMAC was down something like -8% and decided to turn into a family office while Fortress appears to have been down around -17% before shutting its doors.  Have you EVER heard of a long only equity guy closing up shop after a -8 or -17% drawdown? Have you ever heard anyone say that “the SP500 should be shut down because in the 2000’s it has been down over -50% not once but TWICE? It is kind of ridiculous to extrapolate that an entire category of trading is dead because a few guys were down a bit and decided that instead of dealing with the press they would rather just deal with their personal account.

This segways nicely into our next point regarding “a few legendary traders have closed their funds over the past few years.” To think that macro is dead because Soros and Druckenmiller both returned outside money is ridiculous. Forbes has Soros net worth at like $25 billion and Druckenmiller at $4.5 billion. Now I have no idea if their true net worth is half the Forbes number or double the Forbes number but either way they both have billions, have both been working for a long time, and both can still trade, or not trade, while enjoying whatever they feel like enjoying.  And for those that want to say “but Druck was down -5% when he shut down his fund” my response is you’re an idiot. He returned 30%+ forever, all his investors had net gains, and for all you know by the time the year was closed out he was up double digits. Again being down -5% is not really a big deal. In fact the SP500 was down double digits just a few weeks ago…..and I didn’t hear anyone saying “this is proof that market capitalization weighted indexes have lost their touch.” Oh and in case you are wondering by all accounts Druckenmiller made a bunch of money in 2014 and so far in 2015 so I am pretty sure his “loss of touch” was more his “I am sick of shuffling papers I just want to hang out with my family, trade my own money, and watch the Steeler’s play football.

Investing is different from most other professions in that if you are at the top of your game going private gives you a better chance of outperforming than if you are in the public eye. If you are an athlete, musician, artist, doctor, engineer, etc. you need to see people and do things with people in order to know if you are any good or not. Trading is different in that at the end of the day you can see your returns and you don’t have to care if anyone else does.

The last point, at least for today, is concerning the idea that because global macro has done less than awesome post-crisis it is useless and must be dead. Remember 1998, 99, and 2000? Julian Robertson closed his shop, Warren Buffett was down -51%, and value investing was dead. Yeah I wonder how that turned out. Remember around that same time how commodities had done nothing for what some might refer to as “forever”? Over the next 10 years both value and commodities did awesome. By the way what do both Julian and Warren B have in common? They are both called “value” investors but they have also both traded commodities, derivatives, currencies, and anything else that represented “value” to them. At the same time we have someone like Joel Greenblatt who has always been a stock/bond value guy and a Bill Miller who runs equity only mutual funds.  All of these guys would be lumped into the same value bucket and yet they all invest wildly different and have very different business structures.

Some funds, macro and otherwise, have investors who want very low volatility and decent returns. If you are a pension fund that “needs” 7% a year over time then a 20% year is great but a -10% year is the end of the world. The pension funds goals are steady and consistent returns but they have no need for shoot the lights out performance. Other investors on the other hand give a manager a portion of their money and they expect high returns and understand that usually that entails the potential for more risk. There are many other classes of investors but these two will do in order to make this point. Most hedge funds these days, macro or otherwise, are not playing to the sound of the SP500. They are not in the business of playing to some benchmark that someone from the media picked for them. Instead they are trying to play to the benchmark that they have set with their investors. Some of the investors have no economic incentive to beat the SP500 but instead to match their liabilities…..and this is why, or at least a huge part of why, “hedge funds have under-performed” post-crisis.

With all the different strategies and business models inside of strategy categories it is stupid to lump them all together. One of these days I will write a larger post on why the media gets hedge funds wrong but this is one of the key reasons.

All this is a long way of saying, and I am not sure how well I said it, that global macro is not dead and can’t really die. As long as their are trends, and there always are, there will always be some people on the right side and others on the wrong side of them.

By the way we have seen reports of a lot of managers being up double digits even while other funds are struggling. In the case of our newsletter, and of course I have to tout it, we are up around 14% for the year. We are directional macro looking to take 5-15 positions long and short across stocks, bonds, commodities, and currencies at any one time. If this type of thing sounds interesting to you then please take a trial of our service.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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

Cult of the Guru and Independent Thought

You wont believe who said this….but more on that later.

Depression Not Recession

Depression Not Recession

To say that I read a lot of outside research from the sell side, buy side, independent shops, blogs, tweets, and whatever else I can find would be an understatement. I read about one actual book a week along with a gazillion pages and articles of research. I basically get paid to think, read, look at and model data, and……think some more.

That last part is of course key because it is what brings together everything else I do. Sadly I have found that far too many people, and in this case investors/traders, fail to do this. Too many people find a guru or two or three and then attempt to just follow what the guru does, or at least what the investor thinks the guru does. If you actually get to sit in the office with Buffett or Soros or someone similar day after day then maybe this strategy would work–although it probably won’t–but barring that it definitely will not.

We, and by we I hope I mean me and anyone reading this, study great investors to learn the how of what they do and not just what they are doing. I scour 13F’s as much as the next guy…..OK maybe a lot more, but the point remains that if you are not also thinking about both what the famed investor is thinking and whether any of this is applicable to your portfolio. then it is all for naught.

For example look at Warren B. Most people who claim to be following his methodology buy and hold stocks and claim that they are never going to sell. While this may or may not be a successful strategy–for most it ends up being mediocre–it is NOT where Warren B has actually generated most of his outperformance. It is also NOT what he has said to do.

We could go on for a few days on this topic, but the short version is that Warren B says that the ideal stock–sorry, in B terms, it is a company–is one that he never has to sell. Living in reality however WB has regularly bought and sold stocks. In addition he has done more than his share of workouts–in Graham/Dodd speak a workout is what most now refer to as Merger Arbitrage–not exactly a buy and hold forever deal. On top of all this he trades derivatives in massive size, has traded commodities more than once, and finally, at least for now, he gets investment deals that no regular person has a chance of getting into. How many of you did Goldman call up in the 2008 crisis? I was sitting by my phone, but it never rang.

All of this is not to rail on an aspiring Baby Buffett, in fact everyone should read all the Berkshire letters, the Buffett Partnership letters (his Hedge Fund), “How to Trade Like Warren B” by Altucher, “Buffett” by Lowenstein, and all of the academic studies and other books written on the guy. You will learn many things but two stand out. 1-Warren B is a great businessman but a lot of your beliefs about him are probably wrong and 2-You should now have learned enough to adapt parts of his philosophy to your own personality and become your own investor. Notice that I did not say “you can now follow Warren B’s every word and outperform.” The reality is that you can’t. You have to learn from but not worship the great investors.

In the end after you read or listen to anything from anyone but especially supposed “experts” you need to think for yourself.  Failing to do so not only guarantees that over time you underperform but likely makes you drastically underperform.

I love writing this letter and putting my thoughts down on paper. I run a model portfolio to keep me accountable for my official “trade ideas,” but I would hope that anyone reading it would think, read, think some more, and then make a decision about whether what I am saying makes sense to them as well as their portfolios before possibly doing anything.

Why am I all anti-guru all of the sudden? First of all, I have always been anti-guru worship. Second of all, I have had 4 conversations in the past few days regarding the comments of one of my guru heroes. Being unsolicited conversations I thought now a good time to explain my anti-hero worship and blind following.

Professionally my two gurus are undoubtedly Stanley Druckenmiller and Ray Dalio. They are amazing at what they do based on any measure. They make money in most up and down markets, have made more than just about anyone, are both macro, both wicked smart, etc. etc. Basically my goal is to emulate them……but in my own way.

If you are familiar with them, you have already recognized that while they are both macro, they go about things very differently and seem to have different strengths. Where Dalio is king of detailed economic research, Druckenmiller is king of risk taking and risk management.

Both are very much worth studying but guess what?…….They have both been wrong before and will be wrong again.  This is why it is critical that you think for yourself. Everyone, even the best, are wrong on a regular basis.

All this brings us to the next point: A few days ago Dalio came out saying that he expects more QE sooner rather than later. He then clarified what the news reported by writing on LinkedIn his views. Here is the link and it is worth reading for yourself.

The Dangerous Long Bias and the End of the Supercycle

He could be right, and he brings a well thought out case for why he thinks that more QE is on the way. However, I have read it a few times now and disagree with him. I went into why I disagree in the letter this week but let me show you how a guru cannot only be wrong but drastically so.

In my visits to the library in order to read old Barrons (it is both very enjoyable and very enlightening) I came across this article a few months ago (see graphic below). It was published October 12th 1992 by a young Ray Dalio who was then managing $1.5 billion instead of the $150+ billion he is now managing. If you look at the title and then at the date you might be literally laughing out loud. The 1990’s were a lot of things but a depression is not one of them.

Ray Dalio Depression Not Recession

Ray Dalio Depression Not Recession-Barrons October 12, 1992

In the article Dalio goes into why he thought that we were in the early stages of a new depression. Among other things he pointed to was that the Fed had already drastically cut rates and yet the overall economy remained weak.

As you can see in the chart below of the 10-2 yield spread, this piece, and Dalio’s view, came out right at peak Fed ineffectiveness. What I mean by this is basically right around the time that this piece was published, the Fed stimulus started to work, and we left the recession which means that not only was he wrong but he was wrong at exactly the wrong time.

10-2 Yield Spread 1988-1995

10-2 Treasury Yield Spread 1988-1995

As we now know the economy not only did not go into a depression but was actually in the middle of the best 20 year period in the US stock market history. Of course Dalio being a master of the craft must have figured this out since as you can see in the performance table below he proceeded to make a little bit in 1992 and kill it in 1993 (see table in the graphic below).

Bridgewater Pure Alpha Fund Returns

Bridgewater Pure Alpha Fund Returns-Source ValueWalk

Hopefully you see the value in independent thought. Here is a true master, or wizard if you prefer, calling for a depression in something as public as Barrons. He was not only wrong but drastically wrong. If you had blindly followed it, you would have missed some of the best years in market history.

Blindly following a guru, even a guru as good as Dalio, is a sure way to the poor house.  Please think for yourself in all things. Read research (shameless plug: this letter is a great place to find some) but in the end make sure that you agree with any trade idea you find here or anywhere else and that it fits with your current portfolio. Doing anything else is just a way to lose money in the long term.

As a not so side note you should always be thinking things through and making your own decisions. Doing anything else deprives you of learning…..and that sounds like something out of “Principles” by Dalio.

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.