Business Cycle Rotation Part 3Last year I produced several posts that described an exercise that utilizes long term momentum changes between asset classes and the relationship among asset classes to anticipate the business cycle. That series and parts 1 and 2 of this series are linked below.
Parts one and two of the series described the general methodology, presented the matrix with the raw data and showed the process used to consolidate the raw data and begin to draw conclusions around the economy's position in the current business cycle.
Before I plot the distilled sectors onto a stylized business/market cycle overlay, I plot equities, rates and commodities onto an overlay with the Organization for Economic Co-operation and Development (OECD) Composite Leading Indicator (CLI) for the United States. CLI readings above 100 (dashed red line) suggest economic expansion to come while below the 100 line suggests weakness, and perhaps recession to come. The index is currently below 100 but rising toward the 100 line. So still weakening but at a much slower pace.
To help visualize the cycle I plot 10 year rates (inverted), SPX and the Thompson Core CRB index along with the CLI. Viewed in the manner the cycle that began with the bond top appears to be consistent in terms of sequencing. Rates topped, economy (CLI) topped, followed by equities and finally commodities top as the CLI enters the economic contraction phase.
Fast forward to todays configuration. In this perspective, despite the sharp rally in early November, while there is room for a cyclic rally, there is no sign of a lasting bond bottom (see next chart).
Commodities, while off their lows don't appear to be suggesting a new leg up in the cycle (but may be moving that way).
I think of rates as the first mover in the cycle. To believe that the cycle has turned virtuous I like to see ten year rates make a solid top. The ten year note monthly chart has broken above the multi decade downtrend and above the 3.25% pivot. While a bit overbought in terms of momentum and a small RSI divergence is showing up, the structure from the 2020 low is completely intact. Until I see solid signs of a monthly perspective yield top in the two year and ten year, it will be difficult for me to label this as the kind of high that would lead a change in the economic cycle.
The distilled sectors are placed onto stylized market and economic cycle sine curves. If markets (dark blue curve) are correctly anticipating the business cycle (grey curve) the business cycle is somewhere past peak, and should be expected to steadily deteriorate over coming quarters.
In part 5 we will examine the totality of the evidence and draw conclusions around the current cycle and what it implies for 2024.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
USALOLITONOSTSAM trade ideas
Visualizing Business and Market Cycles Through Market Momentum 4In installments 1 - 3 we discussed building a market momentum matrix to help anticipate the business cycle. In this installment we introduce the OECD Composite Leading Indicator and plot the information derived from the momentum matrix onto a stylized business cycle. In the final installment we will make observations and share thoughts around the current cycle.
As a reminder, this is the distilled version of the momentum matrix built in the first 3 installments.
Before I plot the distilled sectors onto a stylized business/market cycle overlay, I plot equities, rates and commodities onto an overlay with the Organization for Economic Co-operation and Development (OECD) Composite Leading Indicator (CLI) for the United States. Readings above 100 (dashed red line) suggest economic expansion to come while below the 100 line suggests weakness, and perhaps recession to come. The index is currently below 100 and falling, consistent with future weakness.
To help visualize the cycle, I plot 10 year rates (inverted), SPX and the Thompson Core CRB index along with the CLI. Viewed in the manner the current cycle appears to be consistent with past cycles in terms of sequencing. Rates top, economy (CLI) tops, equities top, commodities top and finally CLI enters the contraction phase.
Finally, the distilled sectors are placed onto stylized market and economic cycle sine curves. If markets (dark blue curve) are correctly anticipating the business cycle (grey curve) the business cycle is somewhere past peak, and should be expected to steadily deteriorate over coming quarters.
In part 5 we will draw conclusions.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
Bear markets don't last as long as Bull marketsSince we last discussed the odds of a recession here, the prospect of a recession has become consensus. The issue that remains under scrutiny is the duration and intensity of the recession. The slide in stock markets has destroyed nearly US$35trn of global wealth in H1 2022. In terms of timing, the European economy is headed for a recession by year-end, while the US economy could enter a recession by the end of Q1 2023. A mild recession is expected in the US, whilst in Europe, the intensity of the recession will depend on how the energy crisis is managed.
US – Fading the Federal Reserve (Fed)
The US economy is showing signs of growth slowing and inflation peaking. While Gross Domestic Product (GDP) dropped for two consecutive quarters, Gross Domestic Income (GDI) rose in Q1, and real personal income ex-transfer payments increased in Q2. This increases the likelihood of a stronger GDI print in Q2. More importantly, history has shown that the gap between GDP and GDI tends to be closed, with GDP being revised closer to GDI.
The labour market remains strong as jobs continue to be added, wages accelerate, and unemployment remains at a five-decade low. The decline in headline Consuer Price Index (CPI) inflation from 9.1% to 8.5% was a welcome relief to markets. The Federal Reserve path has repriced notabley since the release of the CPI report, with the terminal rate down to 3.55% from 4.25%. While inflation data cooled across non-core and core components, cyclical components like shelter remain elevated. This CPI print validates the case for a 50 basis points (bps) rate hike in September and further moderation going forward (lower than 75bps rate hikes going forward).
US Q2 earnings reports have surprised on the upside, with consensus earnings expectations for the year to the June quarter rising from 5% a month back to 8.77%. It is well documented that yield curve inversions always lead to a recession. Interestingly market performance following the inversion has generally been positive. Since the most recent yield curve inversion in June, equities have rebounded similar to scenarios witnessed in the past.
Europe’s recession will go hand in hand with higher energy prices
Europe’s economy continues to face headwinds from the ongoing energy crisis. Inflation and growth risks have increased further. The Eurozone economy avoided a technical recession in Q2 as GDP rose more than expected by 0.7% Quarter on Quarter (QoQ). However, the growth outlook remains bleak amidst the energy crunch.
Russia has weaponised energy and food supply owing to Europe’s deep dependency. The Euro area is contending with an energy-shock and inflation far greater than in the US. With energy prices, up 42% Year on Year (YoY) in June 2022, energy contributed to more than half of the 8.9% YoY inflation reading in July. Complicating matters further, the Rhine River a pillar of the German, Dutch and Swiss economies for centuries — is set to become virtually impassable at a key waypoint owing to extremely shallow water levels. This will likely halt shipments of energy products and other industrial commodities along one of Europe’s most important waterways1. A prolonged heatwave could create delays for winter energy supplies at a crucial time for Europe. In the near term, the European Central Bank (ECB) will likely focus more on current inflation than on recession risks. As a result, the ECB will front load rates by 50bps on the 8th of September, followed by 25bps moves on the 10th of October and 15th of December.
Growth risks in China imply further policy stimulus
China’s economy continues to disappoint in 2022. China’s Q2 real GDP growth decelerated sharply to 0.4% YoY from 4.8% in Q1, owing to the covid wave and lockdowns since March. While June activity showed signs of a broad-based improvement post lockdown, the growth headwinds have not gone away entirely. The property market turmoil continues to tarnish sentiment with new emerging risks ranging from mortgage payment strikes and declining home sales in July. Fortunately, more effective policy easing is still needed to underpin growth and support demand challenges.
Defensive but not too defensive
Markets like to stay one step ahead. They do not react to the news as much as they anticipate it. ‘Buy the rumour, sell the news’ is a famous idiom for a reason. In most cases, markets start to fall on the risk of an economic recession, not when the recession is all but guaranteed. This year is no exception, H1’s performance was painful for investors because the market anticipated that strong rate hikes would slow the economy even if it was still growing. Once the economy started to show signs of slowing, markets started to predict monetary easing and rebounded in July.
What does our core scenario, where recession is guaranteed, and the only remaining issue is its duration and intensity, mean for investors?
It means that
in all likelihood, the time for very defensive positioning is gone. The recession is priced in, so going to cash or Min Volatility would have been a good idea months ago.
it may be too early for cyclical, aggressive play. Markets have not yet priced in a deep or long recession. A strong, established rebound could still be months away.
This leaves investors with defensively-minded, all-weather options. Equity Investment can protect the portfolio if the market starts to expect a deeper recession or participate in the upside if it anticipates a more technical recession.
Figure 2 compares the performance of the different equity factors during periods of equity drawdowns. We also include in the analysis a strategy (WisdomTree Quality) combining Quality and High Dividend (focusing on Dividend growing, high-quality companies).
Without surprise, the most defensive factor is Min Volatility which reduced the drawdown in all eight periods. Just behind, Quality, WisdomTree Quality and High Dividend would have helped protect the portfolio in 7 out of 8 of the periods. The rest are more cyclical and would have, in most cases, underperformed the market and delivered deeper losses.
Returning to defensively-minded, all-weather options, Figure 3 focuses on the most defensive factors but then looks at the capacity of those strategies to capture positive moves. The upside capture ratio is the percentage of market gain captured by a strategy when markets go up. If the upside capture ratio of a strategy is 60%, then when the market goes up by 10%, that strategy would only go up by 6%.
Clearly, Min Volatility suffers from a very low upside capture ratio. On the contrary, while being defensive (see Figure 2), Quality and High Dividend exhibit a large propensity to capture the market up moves. WisdomTree Quality is the strategy that exhibited the highest upside capture ratio.
In the second half of 2022, awash with uncertainty, a balanced approach between high-quality and dividend-paying stocks could prove very useful in navigating the different ups and downs that could materialise.
Definitions
the Tech Bubble (4 September 2000 to 12 March 2003)
the Financial Crisis (16 July 2007 to 9 March 2009)
the Euro Crisis I (15 April 2010 to 5 July 2010)
the Euro Crisis II (2 May 2011 to 4 October 2011)
the China Crisis (15 April 2015 to 11 February 2016)
Q4 2018 (21 September 2018 to 27 December 2018)
Covid-19 (12 February 2020 to 23 March 2020)
H1 2022 (4 January 2022 to 17 June 2022)
Global equities are proxied by the MSCI World net TR Index.
Min Volatility is proxied by MSCI World Min Volatility net total return index. Quality is proxied by MSCI World Quality Sector Neutral net total return index. High Dividend is proxied by MSCI World High Dividend net total return index. Value is proxied by MSCI World Enhanced Value net total return index. Momentum is proxied by the MSCI World Momentum net total return index. Size is proxied by the MSCI World Small Cap net total return index. Growth is proxied by the MSCI World Growth net total return index. WisdomTree Quality is proxied by the WisdomTree Global Quality Dividend Growth net total return index.
Sources
1 German Federal Waterways and Shipping Administration
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Volatility Trading With The Composite Leading IndicatorThe composite leading indicator is produced by the OECD.
It is an index of components that pertain to each country and is considered a leading indicator of near-future economic performance.
The components for the CLI are:
Component Series (Unit) Source
Work started for dwellings sa (number)
Net new orders - durable goods sa (USD)
Share prices: NYSE composite (2015=100)
Consumer - Confidence indicator sa (normal = 100)
Weekly hours worked: manufacturing sa (hours)
Manufacturing - Industrial confidence indicator (% balance)
Spread of interest rates (% p.a.)
In this piece, we will look specifically at the CLI for the USA. However, I think it will work for most countries ultimately.
I consider you can use the CLI to accurately forecast slowdowns and volatility in US markets and sometimes outright recessions and crashes.
I have overlaid the CLI (the blue waves) with US recessions (red blocks) and added a 20 month SMA to it.
I have also added in dotted orange bands points where CLI takes out its own MA and moves below it which I consider being a "buy vol" signal.
To be clear, these dotted bands are not necessarily recessions , just slowdowns denoted by the composite leading indicator/MA tool. This does not mean however that they are not potentially good volatility trades (as we shall see).
We can see that out of 14 slowdowns and economic recessions. The CLI/MA has a very good success rate if we view it as a "buy" indicator for the VIX .
The buy points denoted by the orange dotted bands are:
1st May 1993
Was followed by a small VIX spike in 1994. A small win could have been achieved by buying vix at $12 and selling for $19 one month later returning over 50%.
21st December 1994
A longer-term hold. Buy signal triggered at around $12.50 and a hold would have been necessary. The positions started generating serious returns in 1996 and maxed out at around $32 in 1997 returning over 150% over 2 years.
1st May 1998
Buy signal was generated at around the $20 mark. This would have returned 100% gains just 3 months later during the VIX spike to over $43.
1st June 2000
Buy signal generated at the $21 mark. This was shortly before the dotcom bubble burst and this would have been a 1.5 year hold generating around 50% return when closed at the onset of the dotcom crisis or could have been held for a return above 90% in 2001 or well over 100% in 2002.
1st March 2002
An interesting dip on the VIX was called by the indicator here. Not sure if just a coincidence or not but it does look suspiciously neat-and-tidy. This triggered at $17.97 and then returned over 100% just a few months later in September of the same year equating to a 5-month hodl.
- 1st Feb 2005
Peak of the post-2000 credit cycle. This trade was a hold. Indicator triggered at 12.01 and the best selling position was 2 years later in July 2007. Returning just under 100% or could have been held to generate bigger returns when the credit crunch kicked in during 2007 and the primary crash occurred during 2008.
1st November 2007
This is obviously the peak of the market for the housing bubble bull-run. The indicator triggered at $20.15 and the ensuing VIX spike maxed out at around $58 returning nearly 300% if the trade was closed one year later.
1st June 2011
A very close to the edge trade which triggered during the double-dip recession in the Eurozone. This is one of the less-good entries with a price of around $25. However, it is very very short term with VIX peaking at $42 over just a few months returning over 75%.
1st March 2015
The indicator triggers on around 1st of March of this year at around the $14 mark and is another medium-term trade with vix peaking at 28 just a matter of months later returning just under 100% as the onset of the Brexit/US Trade War grips market.
1st August 2018
Jitters are evident in CLI as far back as 2018 when the indicator fired and returned a buy price of £13.04. This could have been held for a short-term trade turning over 70% within a matter of months or held longer until the COVID pandemic in 2020 which I consider to have been one of the root causes for the VIX becoming elevated during this time. The longer-term hold would have returned over 400%.
As such, you can see that the crossovers between the CLI signal and the MA on a monthly chart usually preceded volatility bull markets, very serious short-term vix spikes and sometimes even outright recessions.
There are a couple of points to bear in mind here.
Signals sometimes appear up to a year before the "event". That's the whole purpose of this indicator. So in other words, you may have to be prepared to hold. As such, ETF decay which is inherent to instruments like UVXY must be factored in. This strategy is therefore more suited to de facto VIX rather than any of it's leveraged ETF variants.
There are a couple of so-called "false positives" with respect to this indicator calling an "event" very far ahead. For instance, in 2005 it gave a "buy signal" for volatility. This isn't necessarily "wrong" per se, because face it, you'd have been dumping your equities and taking on vol nearly at the very top of the market here. As such there is SOMETIMES ample opportunity to "buy n hold n accumulate". That's another reason why leveraged volatility may not always be suitable per se due to the fact of leveraged ETF decay.
On the other hand, there are some short-term opportunities here which are denominated in terms of only months . Leveraged products may be more suited to these.
I believe that we must exercise judgement if we are to implement this strategy and to judge the relative position of our entries relative to the market when choosing what instruments to employ to benefit from volatility spikes.
I believe this does demonstrate the validity of using CLI and other macroeconomic indicators for volatility investing.
