Equity Market Timing Update November 2010

8/4/2019 Equity Market Timing Update November 2010

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Where are equity markets heading?

The evidence from mean-reversion

modelling: An innovative approach to

Market-Timing and Asset Allocation.

From:

John P. Cuthbert BA, MA, MSc

Independent Financial Economist

November 22, 2010

[email protected]
mailto:[email protected]:[email protected]:[email protected]


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Introduction

Market timing, by common consent, is a tricky often unfathomable business. The

majority of investment professionals place little or no store in it. Our approach is very

different. It draws on eclectic tools (often from process engineering) and other

insights from contemporary research in financial statistics (such as the work of

Andrew Lo at M.I.T), and objectively focuses on economic pricing behaviour.

Our simple aim is to identify the extent to which and when asset prices contain

opportunities that can be exploited. From an empirical or observers point of view,

there are two types of market timing effects: short-term and longer-term. As a

result we use two different types of models to identify these effects.

Perhaps the more interesting of these two types relates to longer-term effects. From

a formal point of view, we can say that if asset markets are rational, then they should

price macro features. These macro features (as the word itself suggests) ought tobe large scale effects, and if markets are also consistently rational, we perhaps

should also be able to detect some sort of consistent pricing of macro evidence from

business cycle to business cycle.

Of course, business cycle asset pricing is a highly controversial area in mainstream

economics, but we would simply say that the evidence is more pervasive - and more

persuasive - than generally assumed. We present some of this evidence here.

Before we launch into that, we ought to first apologise (and perhaps also defend) the

use of statistics here. We apply statistical methods - and often non-standard

techniques - because we are seeking to identify attributes of pricing behaviour that

are not standardly captured by other methods such as stock valuation or rational

asset pricing models. Thats how this approach adds value!

Some of this statistical work will be unfamiliar, and much of it is complicated. Even

so, theres usually an easier way of doing things, and with that encouragement in

mind, we offer here an approach that rests on the presentation of simple diagrams

(rather than maths) that capture more familiar aspects of market pricing behaviour....


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Mean reversion behaviour

One of the most important statistical ways of thinking about and capturing asset

pricing behaviour is mean-reversion1. Not only is mean reversion a really important

area of research, it is also poorly understood, perhaps because it is both diverse

(there are many different mean-reversion processes or models) and complex.

For example, phases of the business cycle -and different business cycles too - often

exhibiting different forms of mean-reverting behaviour (which is one reason why its

hard to make standard valuation techniques work consistently).

Putting these difficulties to one side, its nonetheless true to say that a good deal of

asset pricing behaviour can be meaningfully described as mean reverting. These

mean-reversion phenomena exhibit very strong statistical characteristics (such as

auto-correlated trends, and/or clear probabilistic boundaries at the extreme), and

they are usually associated with real-world business cycle events. This conjunctionbetween statistical and real world events is no small thing; it renders it possible to

identify these mean-reversion phases as profitable market timing opportunities and

also to think about them in conventional strategic terms.

Large scale mean-reversion effects tend to be more describable as trends or

phases (shorter-term effects are better described as trading type phenomena) and

so they are observably present in Asset Allocation performance behaviour. For

example, in comparative Asset Allocation strategies (most obviously between Global

Equities and Global Bonds) the strongest mean reverting asset pricing behaviour

occurs in three phases: at the end of a business cycle; in the bounce from the bottomof the cycle; and finally in the Recovery slowdown phase.

The recent asset pricing (or business) cycle has experienced all three of these mean-

reversion phases, their magnitudes have been statistically significant (and more than

significant in performance terms, and we have constructed statistical forecast models

that are able to precisely define their direction and turning points (their length can

also be estimated through business cycle comparisons, as we will see shortly).

Lets take a look at this recent evidence...

1By mean-reversion we mean any variable whose prospective performance potential is proportionate to its distance from

an average (in practice we use moving averages of different types), though this relationship may well be non-linear ratherthan linear. However, mean-reversion trends are actually modelled using a drift term which tends to have stochastic

properties.


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2010 Mean reversion behaviour

Since the beginning of 2010 we have been pointing out that the post Recovery

bounce (from March 2009) was coming to an end. We predicted and demonstrated

(ably we think) that this phase would come to an end in April, and that subsequently

Global Equities vs. Global Sovereigns would experience a typical end-Recovery period

mean-reversion in which equities under-perform. That has proved to be the case.

There are many ways of statistically describing this type of mean-reversion

behaviour2

but the easiest way to present it pictorially is to use an Information Ratio

(IR) model. The IR is a special type of moving average, and because it is expressed in

standard deviations (i.e. units of variation), as magnitudes approach the limit of

what is normal variation, the probability of a turning point ahead becomes much

more pronounced.

In the IR chart below we have compared the current business cycle to the lastbusiness cycle. This is a Global Equity versus Global Govt. Bond comparison so an

upward-sloping IR trend line implies equity out-performance and vice versa. As can

be seen, the IR trend (or Recovery mean-reversion phase) in the current cycle peaked

at exactly the same standard deviation magnitude as the same phase in the previous

business cycle (2003-04). This peak occurred in April and confirmed that a new mean

reversion phase had begun in which equities would be under pressure relative to

Sovereigns until this new mean reversion phase had come to an end.

2We actually use 5 different models with the main mean-reversion model being the Ornstein-Uhlenbeck equation.

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Global Equities vs. Global Govt Bonds: Two IR mean-reversionpatterns, a business cycle comparison

2003-04 and 2009-10

Recovery phases peak at

same s.d. magnitude

signalling end of equity rally

We are here Forecast


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We have also used this IR model approach (supported by our other models) to

pinpoint the end of the subsequent equity market sell-off phase, which occurred in

late July/early August. In previous business cycles, the equity sell-off phase lasted a

similar amount of time, and ended with a bang (a major sell-off) rather than a

whimper. For all the talk about New Normal, Double-Dip, and the equity Ice Age,

guess what happened this time round?

As you can see from the chart, the ends of the post-Recovery mean-reversion

phases (little yellow circles)3

have been almost exactly synchronous in each of the

last two full business cycles. Julys bottom this year was no different!

Although this coincidence is extra-ordinary, it is purely an empirical feature. There is

nothing about the structure of the models that should determine such extra-ordinary

outcomes, that said,the statistical properties of the behaviour, namely that there

tend to be normal statistical limits to events means that as markets approach thesestatistical limits (in standard deviations), mean-reversion modelling tells us that the

probability of change in the trends direction (or mean- reversion) rises.

It might have otherwise been so, but everything about this business cycle (from a

statistical point of view at least) has pointed to high similarity with previous cycles.

And so being able to think and observe in this statistical way has enabled greater

clarity about market direction when almost every real world event seemed to have

conspired to a different conclusion.

3Please note that we have used our main Ornstein-Uhlenbeck mean-reversion model to determine the length of the mean-

reversion phase, but there are important statistical reasons why this effect should also be mirrored in the IR trend!

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End of mean

reversion phases

3 Information Ratio Business Cycle paths (Global Equities

vs. Govt. Bonds)

In previous Business Cycles equity sell-offs

have been preceded by a collapse in the IR,

and subsequent equity rallies have tended

to coincide with a bottom or bottoming in

the IR!

Current Phase


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Total return impact of mean reversion phases

Of course, investment managers dont think in IR and mean-reversion model terms.

What really matters is total returns! So in our approach it is important that all signals

can be converted into some expected return forecast or general return expectation.

In the two previous business cycles the post-Recovery mean reversion phase ended

with an equity market sell-off. This sell-off was substantial (which is the statistical

effect that drives models to their limits), and if we compare the recent experience to

previous cycles we can assess the degree of similarity.

So the chart above tells us something else about how extraordinary recent events

have been. Not only have the lengths of the Recovery and post-Recovery equity sell-

off phases been similar in length and magnitude when expressed in IR and mean-

reversion terms, the total return behaviour has been very similar too (see green

trend in chart above for the current cycle).

We live in challenging and unsettling times. Debt deleveraging, quantitative easing, a

volatile business cycle and their unravelling uncertainties will linger with us, and

although these events are daunting, mean reversion analysis tells us that none of it is

having any fundamental impact on performance behaviour. Instead the most

important thing to know about the current cycle is that it is being priced in a similar

way to previous business cycles!

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3 Total Return paths associated with mean reversion phases

(Global Equities vs. Govt Bonds)

The ends of previous mean reversion

phases have been preceded by a

substantial sell-off in Equities and this

looks to have occurred in the current

cycle too!


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2011 Expected Mean Reversion behaviour

All this provokes the most obvious and perhaps the most important of questions:

what is likely to happen next?

We can use the mean-reversion models to answer this question.

In the chart below we show the two business cycle comparison again, but this time

with the current IR trend and forecast IR trend shown (the current 12 week forecast

is the part of the red trend curve beyond the small yellow circle).

We can see that in the last business cycle phase (blue trend), although the equity

under-performance phase ended in mean-reversion and total return terms at this

juncture in the cycle, in IR terms equities remained under performance pressure

relative to Government Bonds (the blue trend moves sideways until an obvious

bottom from which an obvious strong equity out-performance trend began in 2005).

The explanation for this is very simple. The IR is a return/risk ratio, and in 2004-05

markets focused on macro risk (the denominator in return/risk) rather than

corporate fundamentals, a form of behaviour which simply reflected the pricing of

the transition from the Recovery to the mid-part of the business cycle.

Something similar is happening this time round. Simply put, markets have a lot to

weigh up with regard to figuring out whether the current expansion can be

sustained. Our IR model forecast and 2004-05 comparison suggest that these

uncertainties wont be resolved for another 21 weeks (period 81 to period 104 on the

horizontal axis). Until then, equities remain at significant risk of major reversals.

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Two IR business cycle paths (Global equities vs. Global Bonds)

In the previous business cycle, the IR trend,

though it bottomed, remained under pressure

for many more months until a stronger

performance phase could begin here.

We are here

IR UNDER PRESSURE


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Current Risk Forecast

Key observations...

Our mean- reversion model analysis tells us that the post-recovery phase whereequities un-ambiguously under-perform Sovereigns is over.

Equities have embarked on a transitional phase (in IR terms) in which, ifuncertainties about the sustainability of the current business cycle expansion can

be resolved, then Global Equities have the potential to embark on a very strong

out-performance phase in 2011.

But the transition through this phase depends crucially on risk behaviour.If these observations are sound, then our risk forecast model is crucial for

determining current Asset Allocation policy.

In the chart below we show the actual relative risk (or tracking error) behaviour of

Global Equities vs. Global Govt. Bonds over the last three business cycles (blue trend)

versus our risk model forecast (red trend).

It is very evident that risk magnitudes can change a great deal but it is perhaps less

obvious that in recent months the forecast risk direction has changed significantly. It

increased sharply in early 2010 before beginning to decline in August.

This type of behaviour has huge ramifications for the pattern of equity/bond returns.

Some of our clients have had some difficulty understanding this point from what

appear to be small movements in the trend pattern of the chart below, so overleaf

we present a more detailed decomposition that sets out the return impact.

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To

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variance (rolling 52W)

variance (rolling 36W)

forecast

Global Equities vs. Global Govt. Bonds Volatility and Forecast

Volatility

Forecast and actual volatility rises in early

2010 before rolling over In August!


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Risk Forecast return decomposition

The essential technical point to grasp about changing risk magnitude is that small

changes can have big implications for the tails of the distribution. Essentially, if

Equity/Bond risk is expanding (and the risk number is greater than in previous cycles),

and if equities are in an under-performance mean reversion phase, then the

drawdowns in the sell-offs will be larger compared to previous cycles. We can see

that in the chart below.

In the chart above we are looking at a comparison of week-to-week Global

Equity/Global Govt Bond active return variation for the present cycle (red line) and

last business cycle (blue line). Putting aside the obvious similarity, in the circled area

we can see that in the current cycle the week-to-week return movements were much

more extreme in April-July relative to the same cyclical period in the last business

cycle phase, and the negative drawdowns tended to be greater than the positivebounces for equities.

From a portfolio point of view, such analysis not only pointed to being underweight

Equities relative to Bonds (which was our recommendation in March), the negative

skew in returns also pointed to the value of some type of portfolio insurance to

protect against equity downside.

However, since July, Equity/Bond risk has contracted, and although the change in risk

might look modest in the chart on page 8, this, coupled with the sea-change to an

equity out-performance phase, has produced a profoundly different pattern of return

variation.

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Global Equities vs. Global Bonds two business cycle return comparison

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As equity risk expands in Jan-

April 2010 the magnitude of the

return swings at the top andbottom of the return range

increases!


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Once again we can see this effect in a business cycle comparison. The chart below

repeats the preceding chart, but this time the period of week-to-week active returns

from July-Nov this year is compared to the appropriate cyclical period in the last

business expansion.

The chart clearly shows that from week-ending July 9, 2010 the active return

performance for Global Equities vs. Global Bonds has had smaller drawdowns (i.e. the

extreme negative values in the red line have been smaller than the blue trend, the

last cycle) and the positive peaks have also been greater in magnitude.

This is a most curious and not well observed development, and one possible

explanation for this positive return bias at this juncture is that it simply reflects the

impact of a Bernanke put, in other words the fundamental support that QE2 is

providing for risk assets!

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Global Equities vs. Global Govt. Bonds 2 business cycle

comparison

In comparison to Jan-Apr, the

pattern of active return variation

in July-Nov 2010 has been biased

towards more positive values.


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Current forecasts

Where does this leave equities?

Main forecast: Equities are in an out-performance phase relative to Global Govt.

Bonds. In a normal cycle this pattern will persist even when equities are overbought.All models are predicting this pattern to remain in place, and the bafflingly high

correlation with the pattern of previous cycles continues to provide further support

for our model forecasts.

Main risks: However, IR mean reversion is not entirely complete, which implies that

Global Equities are still in a period of high pricing uncertainty and remain at risk of

substantial & sustained sell-offs.

Indeed, statistically speaking, a period of consistently positive equity returns cannot

emerge until this pattern changes. That outcome is more likely when the multiple

worries about current business cycle sustainability have been resolved.

Possible sell-offs

As things stand, both our IR and Moving Average forecast models are pointing to a

great deal of choppiness ahead. Indeed, we should be experiencing now the first

equity soft-patch (see the volatile red forecast trend in the chart below), with the

next predicted in January 2011.

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FTSE World vs. Citigroup World Sovereign Bond

52W Information Ratio & IR projected

IR (52W) IR (36W) projected

We

are

here

IR forecast model suggests lots of

volatility ahead


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The potential for equity sell-offs also appears to be visible in the cycle on cycle

comparison of Global Equity/Bond active returns (shown again below). That pattern

also points to a further period of equity weakness ahead and a substantial sell-off in

April 2011 if the pattern of cycle-on-cycle correlation holds.

Of course, as we have made plain, the impact of such patterns even if the

correlation with the previous cycles holds substantially depends on risk variation in

this cycle. That is something we shall monitor for our clients carefully on a week by

week basis.

For now, even with current volatility, all the main Asset Allocation and sector models

point to a pro-Equity bias as being the most profitable disposition based on current

statistical evidence, and to high beta equities in particular (sustainable growth has a

more mixed picture) on a 3 month view.

John P. Cuthbert BA, MA, MSc

Independent Financial Economist

November 22, 2010

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Global Equities vs. Global Bonds two business cycle return

comparison

Equity weakness

ahead here in Jan-

February 2011 With substantial projected

sell-off in late April 2011 if

the pattern repeats

Equity Market Timing Update November 2010

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Transcript of Equity Market Timing Update November 2010