Transcript of SSRN-id2061478
OF STOCK MARKET MACRO TURNING POINTS
DURING GLOBAL FINANCIAL CRISIS APPLICATION TO DYNAMIC
AS SET ALLOCATION INVEST MENT
STRATEGY USING INDEX AND EXCHANGE TRADED FUNDS
February 21, 2012
2012 Copyright by George Bijak
2012 Copyright George Bijak www.cpgli.com | INTRODUCTION 2
ABSTRACT
The formulation of a winning investment strategy for the 2007-2009
Global Financial
Crisis (GFC), also known as the “Great Recession”, essentially
required making one
key judgement that the global banking system would survive the
Lehman Brothers
collapse and identifying the two macro turning points: 2007 top and
2009 bottom of
the market.
Back in late 2008, investors should have concluded that the massive
Central Bank
liquidity injection supported by the global fiscal stimulus had the
capacity to save the
global banking system after the September 2008 Lehman Brothers Bank
collapse.
There was a good chance the GFC would not turn into a 1930s style
Great Depression
contrary to a popular bearish conviction.
Investment strategists need non-subjective indicators to help them
make rational
decisions in times of irrational and emotional market behavior. The
Author has
developed a proprietary Corporate Profits Growth Leading Indicator
(CPGLI) for this
purpose (not fully disclosed here), supplemented by the analysis of
coincident
indicators of the macro-turning points discussed in this
paper.
The analysis identified the following macro indicators of the 2007
market top:
subprime write-downs, M&A at high prices, overleveraged shadow
banking system,
Central Bank’s interest rate cuts, massive Fed liquidity injection
and market
disconnecting from corporate profits trend.
The 2009 market bottom was signalled by the following indicators:
extremely bearish
investors, very low valuations, dominating “risk-off” trade,
interest rates near zero,
falling liquidity injection, expansion of Fed’s balance sheet,
corporate profits
turnaround, falling initial unemployment claims and rising ISM
Manufacturing Index.
2012 Copyright George Bijak www.cpgli.com | INTRODUCTION 3
The paper provides evidence of validity of the active investment
methodology. It
describes the Author’s actual independently audited CPGLI Dynamic
Asset Allocation
Investment Strategy based on the coincident indicators discussed
here and the CPGLI
that after extensive testing has proved to work in “normal” markets
as well as the
most unusual conditions of the start and end of the GFC. The CPGLI
signals not just
the direction of corporate profits growth but also the strength of
growth which
determines conviction and thus whether to use gearing as well. The
strategy returned
83% for the 5 year period from 2006 to 2010 (or 12.9% compounded
per annum)
whilst S&P 500 recorded a negative return during the equivalent
period.
Exchange Traded Funds were the ideal, most convenient, and cost
effective
investment products for the execution of this actively managed
CPGLI Dynamic Asset
Allocation investment portfolio strategy.
1 Table of Contents
3 THE TWO TURNING POINTS
....................................................................................................................
7
4 THE KEY JUDGEMENT: GLOBAL BANKING SYSTEM WILL SURVIVE THE GFC
................................ .............. 9
4.1 Central Banks & Governments saved the global banking system
................................ ...................... 9
4.2 Fed led the rescue by injecting liquidity
.........................................................................................
10
4.3 Liquidity Injections: comparing 2008 and 2001 Recessions with
1930s Great Depression .............. 11
4.4 GFC Comparisons to 1930s Great Depression were misplaced
....................................................... 13
4.5 The liquidity injections helped economy
................................ ................................
........................ 13
5 MARKET TOP INDICATORS 2007
............................................................................................................
15
5.1 Subprime write-downs
..................................................................................................................
15
5.3 Highly leveraged “shadow
banking”...............................................................................................
15
5.4 Fed began cutting interest rates
....................................................................................................
15
5.5 Fed began injecting unprecedented liquidity
................................
................................................. 16
5.6 Market disregarded falling and worsening forecast for Corporate
Profits ...................................... 17
6 MARKET BOTTOM INDICATORS 2009 ................................
................................ ................................
.... 19
6.1 95% of professional investors were bearish at the start of 2009
................................ .................... 19
6.2 Low Market Valuation P/E = 10x (forward)
....................................................................................
20
6.3 “Risk-off” trade was dominating
....................................................................................................
20
6.4 Fed reduced Interest Rates to near zero
................................ ................................
........................ 21
6.5 Corporate Profits resumed growth underpinning the stock market
recovery ................................ . 21
6.6 Liquidity injection started falling
....................................................................................................
22
6.7 Fed expanded balance sheet to buy any unwanted toxic assets
................................ ..................... 23
6.8 Initial Unemployment Claims began falling
....................................................................................
23
6.9 ISM index resumed growth
............................................................................................................
24
7 APPLICATION TO DYNAMIC ASSET ALLOCATION INVESTMENT STRATEGY USING
INDEX AND EXCHANGE
TRADED
FUNDS.............................................................................................................................................
25
2 INTRODUCTION
The 2007-2009 Global Financial Crisis (GFC), also known as the
Great Recession, was a
challenging period for investors and advisors. Conventional
investment strategies
designed to reduce risk did not perform satisfactorily.
Diversification failed to protect
investment portfolios as the crisis significantly increased the
correlation within global
markets and across normally uncorrelated asset classes.
Investment strategists need non-subjective indicators to help them
make rational
decisions in times of irrational and emotional market behavior. The
Author has
developed a proprietary Corporate Profits Growth Leading Indicator
(CPGLI) for this
purpose (not fully disclosed here), supplemented by the analysis of
coincident macro-
turning points indicators discussed in this paper.
It is postulated that the formulation of a winning investment
strategy for the GFC,
essentially required making one key judgement that the global
banking system would
survive the Lehman Brothers collapse and identifying the two macro
turning points:
2007 top and 2009 bottom of the market.
Section 4 explains why in late 2008 investors should have concluded
that the massive
Central Bank liquidity injection supported by the global fiscal
stimulus had the
capacity to save the global banking system after the September 2008
Lehman
Brothers Bank collapse. There was a good chance the GFC would not
turn into a
1930s style Great Depression contrary to a popular bearish
conviction.
Section 5 discusses the indicators that helped identify the 2007
market top:
› Subprime write-downs,
› Highly leveraged “shadow banking”,
› Fed began injecting unprecedented liquidity,
› Market disregarded falling and worsening forecast for Corporate
Profits.
Section 6 analyses the indicators associated with the 2009 market
bottom:
› 95% of professional investors were bearish at the start of
2009,
› Low market valuation P/E = 10x (forward),
› “Risk off” trade was dominating,
› Fed reduced interest rates to near zero,
› Corporate Profits resumed growth underpinning the stock
market recovery,
› Liquidity injection started falling,
› Fed expanded balance sheet to buy any unwanted toxic
assets,
› Initial Unemployment Claims began falling,
› ISM Manufacturing Index resumed growth.
The last Section 7 describes the Author’s actual independently
audited CPGLI
Dynamic Asset Allocation Investment Strategy based on the
indicators discussed here
and the proprietary Corporate Profits Growth Leading Indicator
(CPGLI) that after
extensive testing has proved to work in “normal” markets as well as
the most unusual
conditions of the start and end of the GFC. The CPGLI signals not
just the direction of
corporate profits growth but also the strength of growth which
determines conviction
and thus whether to use gearing as well. The strategy returned 83%
for the 5 year
period from 2006 to 2010 (or 12.9% compounded per annum) whilst
S&P 500
recorded a negative return during the equivalent period.
The strategy actively switched between Cash and Index and Sector
Exchange Traded
Funds to maximize returns and reduce risk.
2012 Copyright George Bijak www.cpgli.com | THE TWO TURNING POINTS
7
3 THE TWO TURNING POINTS
The Global Financial Crisis (GFC) amplified the importance of
making correct top-
down macro calls on the broad direction of the economy and the
stock market at a
time of extreme turbulence. There were two major macro-turning
points (2007 top &
2009 bottom) which, when spotted on time, helped to determine the
winning
dynamic asset allocation investment strategies for the GFC period
(on Chart 1).
Chart 1. The USA Stock Market Turning Points during GFC - Top &
Bottom
Recognizing that a stock market bubble was nearing its top in 2007
and switching
funds to more defensive positions, such as cash and USA Government
Bonds, would
cushion investors from the subsequent crash that saw the S&P
500 index down by
56%.
2012 Copyright George Bijak www.cpgli.com | THE TWO TURNING POINTS
8
Then, investors should have recognized the bottom of the market in
March 2009 and
the beginning of its sharp V-shape recovery and decisively
reallocated more assets to
equities to participate in a strong 85% rally till the end of
2011.
Traditional investment strategies, such as diversification within
and across asset
classes that normally have little correlation, are designed to
reduce risk and volatility
of an investment portfolio. But when all risk asset classes fell
together, these
strategies could not sufficiently protect investors on the
downside. The crisis
unnerved most investors around the globe and synchronized their
risk-averse
behaviour resulting in a very high correlation between all global
market risk asset
classes. The crisis disarmed the risk reduction benefits expected
from diversification
in normal times.
There were basically two trades during the GFC to choose from:
“risk off” or “risk on”.
The “risk-off” approach dominated after the heavy falls and
essentially involved
moving to cash, USA or German bonds, Swiss Franc and Gold whilst
avoiding anything
perceived risky i.e. all global equities, all corporate debt (even
the best quality) and all
alternative investments.
Investors needed to focus on the key political macroeconomic policy
decisions and
unemotional, reliable indicators signalling the major market
turning points to make
correct investment decisions in a time of crisis. These issues will
be now discussed in
more detail.
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
SURVIVE THE GFC
Lehman Brothers, one of the largest and oldest Wall Street
investment banks,
collapsed under massive debt in mid-September 2008, pushing markets
to horrific
depths and dashing hopes for a quick end to the recession. The
stock market reacted
assuming the worst - the repeat of the 1930s Great Depression was
now widely
expected. Global financial credit shut down and banks stopped
overnight lending
between themselves. The next likely scenario was a global run on
the retail banks.
At times of extreme financial crisis, investors have to first
answer the fundamental
question: will the global banking system survive in its current
ownership structure?
If the answer in 2008 was “no” the global economy would most
likely end in a major
depression similar to the 1930s when stocks fell 90% across the
board. In this case,
investors would have been wise to get out of the market altogether,
cutting losses
and putting away their cash in a very safe place guaranteed by the
Government, or
the safety of their homes.
The correct “yes” answer in 2008 would justify holding on to
the stocks that were not
sold in time, while looking for an opportunity to top up equity
investments as soon as
the market formed its ultimate bottom.
4.1 Central Banks & Governments saved the global banking
system
The main Central Banks supported by their Governments effectively
stopped the
global economy from turning into the Second Great Depression by
undertaking
decisive policy initiatives commensurate with the extent of the
crisis. Central Banks
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
10
publically stated many times that the Fed would do whatever it took
to stabilize the
financial system and not repeat the mistakes of the 1930s when it
did not inject
liquidity, did not reduce interest rates sufficiently and was not
supported by any
meaningful fiscal stimulus. The other leading central banks
concurred. (Source:
http://www.federalreserve.gov/newsevents/speech/2009speech.htm ).
The Fed in concert with the major foreign central banks, pumped
unlimited liquidity
into the financial system, drastically reduced interest rates and
followed with massive
rounds of quantitative easing aiding the later recovery.
Governments around the
world supported the effort with strong fiscal stimulus to ease the
pain of the Great
Recession and rekindle economic growth over the next few years (the
role of
Governments is not discussed in detail in this paper because its
programs have
lagging impact on the stock market). The strategy worked: the
financial system
survived without bankrupting any of the remaining big institutions
that were
considered “too big to fail” and the economy and stock market
recovered.
4.2 Fed led the rescue by injecting liquidity
The major leading force that saved the financial system was the
unprecedented level
of liquidity injected by the USA Federal Reserve Bank beginning in
December 2007 at
the first sign of the cracks.
The Fed extended the eligibility for central bank funds to
non-banks and was
accepting any quality assets as collateral for cash at rock bottom
discount window
rates. Prime interest rates were reduced drastically. Moreover, the
Fed with
Government came directly to the rescue of major financial
institutions including AIG,
Freddie Mac, Fannie Mae and coordinated similar actions with the
central banks
around the world. In a nutshell the Fed, in concert with the other
central banks,
engaged all monetary policy tools to the maximum and publically
stated it was
prepared to continue using an open cheque book for as long as it
took to wash the
toxic debt from the banking system.
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
11
Back in late 2008, the Central Banks’ and Governments’ behaviour
should have led
investors to a conclusion that the financial system was, in all
probability, to survive as
long as the supportive monetary and fiscal policies continued. In
parallel, many
Governments immediately guaranteed bank deposits to prevent
potential runs on the
banking system.
4.3 Liquidity Injections: comparing 2008 and 2001 Recessions
with 1930s
Great Depression
The following analysis focuses on one of the main indicators of the
liquidity
injections: “The Total Borrowings of Depository Institutions from
the Federal
Reserve”.
Liquidity injections are important to the health of the banking
system in times of
extreme crisis. The following analysis shows that the large
liquidity injection in 2001
was followed by an economic recovery. By contrast, the lack of such
intervention in
the 1930s was one of the factors leading to the Great
Depression.
During the GFC, the Fed applied the same monetary tools as in 2001-
only on a much
bigger scale. The total injection topped $700 billion which makes
all other injections
look like an insignificant noise around the zero line as the Chart
2 below shows.
Hence, investors would have been justified to expect an economic
and market
recovery given the unprecedented scale of this action.
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
12
Chart 2. Borrowings from Fed were unprecedented during the GFC (in
$bn)
Source: cpgli.com, Fed
A dollar today is worth less than a century ago so we need to look
at the change:
Chart 3. Borrowings from Fed (% change)
Source: cpgli.com, Fed
The story is the same: the 4,000% change in Liquidity during the
GFC was the biggest
ever.
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
13
Ben Bernanke has no equals in the 100-year history of the USA
Central Bank – the
injection that began in December 2007 was the biggest, measured in
dollars and in
percentage change terms. The change was more than double that of
the previous
record set by Fed Chairman Alan Greenspan in Sept 2001. The
Greenspan injection is
the second largest spike on the “change” chart, but in dollar terms
Greenspan’s
injection was a small drop in Bernanke’s ocean of liquidity.
4.4 GFC Comparisons to 1930s Great Depression were
misplaced
Parallels between the GFC and the 1929 stock market crash, which
was followed by
the 1930s Great Depression, were misplaced because the Central
Banks’ behaviour
was totally different this time around.
In the 1930s, the Central Banks, as admitted by Fed Chairman Ben
Bernanke, did not
do enough to save the banking system by failing to inject any
meaningful liquidity on
time.
4.5
The liquidity injections helped economy
The 2001 liquidity injection was followed by GDP recovery, while
the 1930s period
suffered the Great Depression in the absence of any major
injection.
Chart 4 tells the story: GDP (red line - right axis) was up
following the strong 2001 and
2007-09 spikes in liquidity (blue line – left axis). By contrast,
GDP fell in 1930s Great
Depression in absence of the Fed’s intervention.
2012 Copyright George Bijak www.cpgli.com | THE KEY JUDGEMENT:
GLOBAL BANKING SYSTEM
WILL SURVIVE THE GFC
Chart 4. GDP recovered following Liquidity Injections in 2001 &
2007-09
Source: cpgli.com, Fed
Timing and forecasting the extent of the economic recoveries as a
result of the
injection of liquidity is difficult. It depends on many variables
and is subject to
countless risks. Predicting the stock market behaviour is even
harder because it is
influenced by many more risks and psychological factors. For
example, the 2001
September liquidity spike was followed by one and a half years of a
declining stock
market that only recovered in 2003-04.
Other tools and leading indicators are needed to fine-tune a
forecast of the market
macro-turning points. Especially useful is an outlook for Corporate
Profits growth
because profits lead the stock market which in turn leads economic
growth during
recoveries. Other indicators may serve the same purpose.
2012 Copyright George Bijak www.cpgli.com | MARKET TOP INDICATORS
2007 15
5 MARKET TOP INDICATORS 2007
Looking back at 2007, the USA Subprime Housing Loans Crisis had to
eventually burst
the stock market bubble. However, back in 2007 it was not that
obvious.
5.1
Subprime write-downs
Investors got used to enjoying the four long years of the bull
market from 2003 to
2007. The S&P 500 index doubled and even the initial large
subprime write-downs by
Merrill Lynch, Bank of America, Citibank and others in 2007 were
shrugged-off by the
market. Confidence was extremely high that current conditions would
continue.
5.2 M&A frenzy at high prices
The stock market gains were additionally fuelled by an
unprecedentedly strong M&A
activity around the world. Particularly, Private Equity players “on
borrowed steroids”
following their successful multi-year run, engaged in an
“acquisition frenzy”
leveraging their already leveraged bets and paid record prices.
M&A transactions
added to brokers’ short term profits and delayed the market
collapse.
5.3
Highly leveraged “shadow banking”
Much of the financial engineering wealth generating activities were
financed by the
extremely leveraged “shadow” banking system functioning outside the
more
controlled and regulated traditional banking. The structured
products, consisting of
subprime mortgage assets of doubtful quality, were offered as the
safest income
investments, sometimes with an independent AAA stamp of
approval.
5.4
Fed began cutting interest rates
The continuous market optimism was aided by initial cuts to
interest rates by the USA
Central Bank in mid-2007. This came at the first sign of problems
in response to a 10%
market correction. The Fed only delayed the inevitable
collapse.
2012 Copyright George Bijak www.cpgli.com | MARKET TOP INDICATORS
2007 16
The fact that Fed had to start easing interest rates, following
many years of bull
market, was an indicator of the looming problems and a weaker stock
market ahead.
The arrow on Chart 5 points to the beginning of the USA rates cuts
cycle in mid-2007
that has lasted until today. In early 2012, Fed surprised the
market by extending a
previously announced target for holding the interest rates near
zero to mid-2014.
This will aid the economy and jobs recovery.
Chart 5. Beginning of Interest Rates cuts coincided with market Top
Source: cpgli.com, Fed
Fed began injecting unprecedented liquidity
The coincident indicator of the market top from Fed’s perspective
was the massive
injection of liquidity that began in December 2007 (see Chart
2&3 above). It was a
clear sign that the financial system was stretched to the limit and
beginning to crack
under the mountain of debt secured by near worthless subprime
mortgages. The Fed
probably sensed the looming crisis early and responded with
unprecedented force
and without a delay.
The response saved the banking system but could not stop the stock
market from
crashing.
2012 Copyright George Bijak www.cpgli.com | MARKET TOP INDICATORS
2007 17
The NBER Business Cycle Committee officially declared, 18 months
after the initial
December 2007 liquidity injection, that the Great Recession started
in December
2007 (grey bar on Chart 6).
Chart 6. Fed began injecting massive liquidity at the Top of the
market and beginning
of the Great Recession
Profits
It was only a matter of time for the market to fall because
aggregate Corporate
Profits were falling throughout the whole year in 2007 and
valuations could not hold
up for much longer. The Fed intervention, M&A frenzy and the
bullish momentum
only prolonged the inevitable closing of the gap between the
Corporate Profits trend
and market levels.
Corporate Profits is a fundamental driver of stock market
valuation. Value equals
profits multiplied by a valuation multiple such as Price Earnings
ratio (P/E).
Historically, over the past 60 years, there was a high, 90%+,
correlation between USA
Corporate Profits and S&P 500 index. The stock market usually
finds it hard to grow
2012 Copyright George Bijak www.cpgli.com | MARKET TOP INDICATORS
2007 18
point. By the end of 2007, USA Corporate Profits had been falling
for four consecutive
quarters and, despite that, the market was marching up and
valuation multiples were
remaining high (forward P/E ratio was above 15). The market fell
10% in mid-year
but the Fed managed to bring it back to life for a while by cutting
rates. Then, more
subprime write-offs were announced and profits kept falling. The
Profits-Market Gap
was widening signalling the inevitable end of the bull
market.
Chart 7. The widening Gap between Corporate Profits and Market
throughout 2007,
signalled the looming market top.
Source: cpgli.com
Investors should have followed the widening gap during 2007 with a
gradual
reduction of exposure to equities to protect their capital and
reduce the risk across
their investment portfolios. Catching the last gains of the bull
market against the
clearly emerging negative Corporate Profits trend carried a very
high risk.
The bubble was ready to burst and could be pricked by any bad
enough news. When
it suddenly happened, everyone looked for the exit and it was too
late to protect the
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 19
6 MARKET BOTTOM INDICATORS 2009
Investors who “survived” the 2008 stock market crash followed by
the Great
Recession, second only in severity to the 1930s Great Depression,
were
understandably not in a mood to think about re-entering the market.
The GFC left the
market in tatters after a 56% fall (S&P 500 index fell from
1,565 level on October 9,
2007 to 676 on March 9, 2009 – see Chart 1).
Instead, investors were collectively “licking their wounds”,
investing what was left
cautiously, mainly in “risk-off” strategies. This trend has more or
less persisted to this
day (early 2012). Long bonds, a perceived “risk-off” asset class,
have been receiving
strong funds inflow whilst equities have been avoided thereby
missing an 85% rally
over the last three years.
Investors do not seem to be overly concerned that bonds can be also
a very risky
asset when interest rates start rising again. The 10-year USA bond
yield, currently
below 2%, is historically low and may eventually go up, leading to
the loss of capital
value.
6.1
95% of professional investors were bearish at the start of
2009
Retail investors panicked first during the GFC and professional
managers had no
choice but to follow the avalanche of relentless sell orders while
the media was
predicting an inevitable re-run of the 1930s Great
Depression.
The Bloomberg Global Confidence Index was at rock bottom by the end
of 2008. Only
5% of professional investors were bullish about the future of the
stock market. The
overwhelming 95% of investors were completely bearish, expecting a
total collapse of
the global financial system and the stock market.
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 20
6.2
Low Market Valuation P/E = 10x (forward)
Low investor confidence combined with a very low P/E multiple of
around 10x
forward, should had been treated as a contrarian indicator of
better times ahead -
assuming the banking system was to survive and cyclical upswing was
to begin.
6.3
Overly bearish fund managers invested accordingly to “risk-off”
principles were often
guided by their conservative fiduciary duties and risk reduction
demands from
understandably “paralysed” clients. Their over-cautiousness led to
missing some of
the strong V-shape recovery that followed in 2009-2011.
Chart 8 shows the prevailing conservative investment approach.
Average allocation to
stocks by major Wall Street strategists was reduced in line with
the falling stock
market through to early 2009 and then gradually increased with the
rising market.
Chart 8. Allocation to stocks followed the direction of the market
with a delay
Source: Bespoke Investment Group, Bloomberg Survey of Wall Street
Strategists, Jan 2010. Reproduced with permission.
The point of lowest allocation to equities coincided with the March
2009 market
bottom and, looking back, it was the best time to buy equities at
the beginning of the
multi-year V-shape rally.
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 21
6.4
Fed reduced Interest Rates to near zero
The Fed followed the market on the way down by cutting rates to
almost zero by the
end of 2008. Soon after, the market reached its bottom and began
the recovery –
Chart 9.
Chart 9. Rates cut to near zero preceded market Bottom.
Source: cpgli.com, Fed
recovery
The market must eventually go up when profits are growing strongly
while valuation
multiples are very low (Chart 10). This is the time when
fundamentals drive the
valuations regardless of the pessimism. If the market did not rise
in the face of rising
profits it would lead to an unsustainable misalignment between the
yields available
from stock dividends and debt products.
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 22
Chart 10. Corporate Profits V-rebound was followed by market
recovery
Source: cpgli.com, Fed
6.6 Liquidity injection started falling
The peak of liquidity injection (measured in $bn) coincided with
the bottom of the
market – Chart 11. Less borrowings from the Fed indicated
stabilization of the
financial system.
Chart 11. Reduction of Borrowings from Fed coincided with market
recovery
Source: cpgli.com, Fed
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 23
6.7
Fed expanded balance sheet to buy any unwanted toxic assets
Early in 2009, the Fed embarked on the assets purchase program;
mainly U.S.
Treasury Securities (TREAST) and Mortgage-backed Securities (MBST).
This required
an expansion of its Balance Sheet from approximately $500bn in the
early 2009 to
above $2.4 Trillion in 2011. The program helped clean out the toxic
debt that was
clogging the banking system. The fresh funds enabled banks to
re-engage in economy
to actively support job creation initiatives. The stock market
viewed it positively with
a rise – Chart 12.
Chart 12. Fed Asset Purchase programs coincided with market
rise
Source: cpgli.com, Fed
6.8 Initial Unemployment Claims began falling
Unemployment is a lagging indicator of the stock market and
economic growth.
However, the Initial Unemployment Claims trend usually improves
much earlier.
Historically, the peaks in Initial Claims signalled the end of
recession and the stock
market usually sensed it even earlier. This was the case again
during the GFC
recession: Initial Claims started falling soon after the market
& economy began
recovery - Chart 13.
2012 Copyright George Bijak www.cpgli.com | MARKET BOTTOM
INDICATORS 2009 24
Chart 13. Initial Unemployment Claims peaks coincided with the end
of recessions
Source: cpgli.com, Fed
6.9 ISM index resumed growth
Once the economy started to recover - the ISM Manufacturing Index
followed
consistent with its behaviour in the previous cycles. Chart 14
shows that recessions
ended after a sharp upward reversal of the ISM index.
Chart 14. ISM Manufacturing Index began recovery at the end of
recessions
Source: cpgli.com, Fed
INVESTMENT STRATEGY USING INDEX AND EXCHANGE TRADED FUNDS
25
7 APPLICATION TO DYNAMIC ASSET ALLOCATION
INVESTMENT
STRATEGY USING INDEX AND EXCHANGE TRADED FUNDS
This section describes the Author’s actual CPGLI Dynamic Asset
Allocation Investment
Strategy based on his proprietary Corporate Profits Leading
Indicator (CPGLI) and
coincident macro-turning points indicators discussed in this paper.
The strategy was
monitored and audited in real time by an independent organization
Timertrac.
The CPGLI strategy returned 83% for the 5-year period from 2006 to
2010 (12.9%
compounded per annum) whilst S&P 500 recorded negative return
(0.9%). The CPGLI
Dynamic Asset Allocation Investment Strategy actively switched
between Cash/
Inverse Exchange Traded Funds (ETF) and Index/ Sector leveraged ETF
to maximize
returns and reduce risk – Table 1.
Table 1. The CPGLI Dynamic Asset Allocation investment strategy
performance.
Return % CPGLI strategy S&P500 CPGLI strategy
5 years Returns
Total 5y 83.3 (0.9)
Annual 5y 12.9 (0.2)
INVESTMENT STRATEGY USING INDEX AND EXCHANGE TRADED FUNDS
26
The strategy anticipated that the market would reach a peak and
correct sometime in
the second half of 2007 and avoided equities by re-allocating to
cash and occasional
inverse ETF positions. Thanks to the cautious approach, the
strategy avoided the first
phase of the market crash till March 2008 when Bear Stearns
collapsed. In 2008,
despite using leveraged ETFs, the strategy registered a lesser fall
(24.8%) than the
S&P 500 market index which fell by 37.5%. In addition, the
strategy’s investment risk
was relatively reduced. The CPGLI Strategy’s Sharp Ratio and Ulcer
Index were higher
than that of S&P500, reflecting the lower risk.
The strategy has been fully invested in bullish equities leveraged
ETF since early 2009
at the market bottom through 2010 during the V-shape market
recovery. This
resulted in the strategy significantly outperforming S&P500
market index. Table 2
summarizes the CPGLI strategy trading positions.
Table 2. CPGLI Dynamic Asset Allocation investment strategy trading
positions
CPGLI
strategy
return %
trading positions
2010 47.3 11.0 100% in up to 3x bullish equities ETFs
2009 79.5 19.7 100% in up to 3x bullish equities ETFs
2008 (24.8) (37.5)
Up to March 2008 (Bear Stearns collapse) 100 % in cash.
Post March 2008, gradually allocated to equities ETFs.
Failed to anticipate Lehman Brothers collapse in 09/2008.
2007 (3.4) 3.6 Mix of cash and inverse bearish ETFs
2006 (4.5) 11.7 Predominantly cash
Total 5 years return 83.3 (0.9)
Annual 5 years return 12.9 (0.2)
8 CONCLUSION
The 2007-2009 Global Financial Crisis (GFC) was a challenging
period for investors and
advisors. Conventional investment strategies designed to reduce
risk did not perform
satisfactorily. Diversification failed to protect investment
portfolios as the crisis
significantly increased the correlation within global markets and
across normally
uncorrelated asset classes.
The strategy that worked and was implemented, significantly
outperforming the
market, involved application of the Corporate Profits Growth
Leading Indicator
(CPGLI) and a range of macro-turning points indicators discussed in
this paper. The
methodology, supplemented by making the key judgement that the
global banking
system would survive the Lehman Brothers collapse, accurately
identified the two
critical market macro-turning points: the late 2007 top and the
early 2009 bottom.
Exchange Traded Funds were the ideal, most convenient, and cost
effective
investment products for the execution of this actively managed
CPGLI Dynamic Asset
Allocation investment portfolio strategy.
This paper has identified a number of the GFC market top and bottom
coincident
macro-turning points indicators. It analysed factors that led to
the conclusion that
global banking system would survive the Lehman Brothers
collapse.
The Central Banks and major Governments played a pivotal role in
preventing the
repeat of the 1930s Global Depression through a decisive use of all
available
monetary and fiscal policy tools.
9 REFERENCES
Baks Klaas, Kramer Charles, “Global liquidity and Asset Prices:
Measurement,
Implications and Spillovers”, IMF Working Paper 99/168
Bernanke Ben, “The Crisis and the Policy Response”, At the Stamp
Lecture, London
School of Economics, January 13, 2009,
http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
Bernanke Ben, Gertler Mark, “Monetary Policy and Asset Price
Volatility”, Economic
Review, 4th Qtr 1999
Bernanke Ben, Gertler Mark, “Should Central Banks Respond to
Movements in Asset
Prices?” Princeton University 2001
Bernanke Ben, Kuttner Kenneth, “What explains the Stock Market's
Reaction to
Federal Reserve Policy”, FRB of New York, October 2003 Number
174
Bernanke Ben, Mishkin Frederic, “Inflation Targeting: A new
Framework for Monetary
Policy” , NBER Working Paper No. 5893, July 1997
Bijak George, A Concept of Multi-entity Accounting for Capital
Distribution,
International Conference General Accounting Theory, University of
Economics
Krakow, April 2003,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=818804
Blundell-Wingnall Adrian, Bullock Michele, “Changes in the
characteristics of the
Australian business cycle: some lessons for monetary policy
from the 1980s and early
1990” , RBA Economic Research Department paper #9212 December
1992
Board of Governors of the Federal Reserve System, “Speeches of
Federal Reserve
Officials” , Federal Reserve 2008, 2009, 2010, 2011,
http://www.federalreserve.gov/newsevents/speech/2009speech.htm
2012 Copyright George Bijak www.cpgli.com | REFERENCES 29
Bordo Michael, Oliver Jeanne, “Monetary Policy and Asset Prices:
Does "Being
Neglect" make sense?, IMF Working Paper 02/225
Collyns Charles, Senhadji Abdelhak, “Lending Boom, Real Estate
Bubbles and the
Asian Crisis” , IMF Working Paper 02/20
Dahlquist Magnus, Harvey Campbell R., “Global Tactical Asset
Allocation” , NBER 2001
Flood Darren, Lowe Philip, “Inventories and the business
cycle” , RBA Economic
Research Department Paper 9306 June 1993
Griffin John, Ji Susan, Martin J.S., “Momentum Investing and
Business Cycle Risk”,
2002
Kose Ayhan, Otrok Christopher, Whiteman Charles, “Understanding the
evolution of
world business cycles” , IMF Working Paper 05/211
Ludwig Alexander, Slok Torsten, “The impact of changes is stock
prices and house
prices on consumption in OECD countries”, IMF Working Paper
02/1
Rabanal Pau, “Monetary policy rules and the U.S. business cycle
evidence and
implications” IMF Working Paper 04/164
Schinasi Gary, “Asset prices, Monetary Policy and the Business
Cycle” , IMF Working
Paper 94/6
Silvapulle Paramsothy, “Business cycle asymmetry and the stock
market”, School of
business LaTrobe University paper October 1997 no: A.97.22
The Conference Board, “Business Cycle Indicators Handbook” ,
Dec 2001
http://www.conference-board.org/pdf_free/economics/bci/BCI-Handbook.pdf
Zarnowitz Victor, “Business Cycles – theory, history, indicators,
and forecasting” ,
National Bureau of Economic Research
1992 http://www.nber.org/books/zarn92-1