Hi Guys,
A few weeks ago, I suggested that a top-down, econometric-driven approach to making investment decisions might be beneficial to many Forum members. If you favor an aggressive frequent trading policy, this type of analyses is definitely not your cup of tea.
I’m sure everyone has been exposed to the financial communities warnings that by missing just a few of the best performing days, irreparable damage would do violence to your portfolio. Of course, these same sell-side hucksters often omit demonstrating the very positive portfolio impact on returns that missing the worst performing days would similarly produce. Both presentations are just bad science. The likelihood of either event series happening is near zero, and it is a worthless exercise to worry about a nonevent.
Market timing can have a major impact on end wealth, especially when considering the basic equity/fixed income portfolio asset allocation mix. A prudent question is: How does an amateur investor accomplish this task with respectable reliability? The market unknowns and uncertainties will never be fully eliminated. This smells like a job for probability theory and statistical analyses.
Several models have been developed and updated for many decades that confront this issue. I have often mentioned, but not to endorse, such a model proposed and developed by Elaine Garzarelli. After some initial successes, her predictions have recorded mixed results in more recent market stress tests.
Garzarelli’s market timing model includes 14 separate indicators. These 14 signaling components are grouped into 4 equally weighted sectors. The four groupings reflect Cyclical, Monetary, Value, and Market Sentiment factors.
The Cyclical group contains industrial production and corporate earnings measurements. The Monetary group consists of seven elements related to monetary policy such as interest rates, yield curves, and money supply. The Value group is comprised of inverted composite corporate earnings yield-to-interest rate metrics and P/E equations. The Sentiment group incorporates surveys of the number of bullish financial advisors and mutual fund cash levels. All this is very complex with a lot of computer-driven, numbers crunching, linear curve fitting analytics.
More simple models do exist and have demonstrated reasonable prediction accuracy. As Albert Einstein remarked: “Everything should be made as simple as possible, but not one bit simpler. ”
A much simpler method is to deploy moving averages to modify the baseline equity/fixed income mix. Simply increase the fixed income allocation when an equity market proxy like the S&P 500 Index price record penetrates below its 200-day moving average, and reverse the adjustment when the penetration is in the opposite direction.
An alternate path to forecasting market behavior is to explore corporate earnings growth rate possibilities. Excluding speculative perturbations (which in excess contribute to the creation of bubbles and panics), earnings growth directly impacts the fundamental returns delivered by the equity markets.
A tight correlation exists between corporate profits and GDP growth rate. So, if GDP growth rate could be reliably forecasted, then tightly-linked market movements could be accurately assessed. The simplest definition of a recession is two consecutive quarters of negative GDP growth rate. Therefore, if we can reliably project an upcoming recession, we can anticipate poor equity market performance.
One challenging alternate portfolio realignment approach is to adjust the top-tier asset allocation holdings as a function of a recession probability projection (RPP). There are many complex models used to complete that RPP analysis. None are totally reliable signaling instruments.
One such RPP model has been developed and updated by Credit Suisse. Credit Suisse (CS) wisely cautions that “ modeling is an aid to judgment, not a substitute for it.” That’s a very perceptive warning for any complex econometric model. A paper that summarizes the CS analytical approach is found at the following confusing and extended address:
http://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=856579291&serialid=ZXa19to77uOvxxu3QDrFZhjlKfCBy8H58U1BxvxgQG4= The CS construction is representative of a host of competing formulations; I have no idea of the relative accuracy or the false signal frequency of these alternate RPP models or even of the CS model itself.
The CS model includes 7 factors like the Fed Funds rate, S&P 500 percentage change, payroll growth, housing permits, consumer expectations, jobless claims, the TED short term interest rate spread, and relative energy prices. Most of the required input data is entered for either 6-month periods or year-over-year changes.
Some modelers use over two hundred signal generators. I have no idea how they handle this data overload condition. I get confused when the factors reach the high single digit level, and become seriously suspicious over potential data mining contamination.
I prefer a modern form of Occam’s Razor: The simplest explanation (read model) is usually the most robust and reliable. Simple RPP models also exist.
The New York Fed has examined the recession forecasting issue extensively. They have examined several independent variables to guide a recession prediction, and have concluded that “in predicting recessions two or more quarters in the future, the yield curve dominates the other variables.”
They conclude that: “The yield curve – specifically the spread between the interest rates on the ten-year treasury note and the three-month Treasury bill – is a valuable forecasting tool.”
To examine their findings and judge if it is a candidate to be added to your decision-making toolbox, I suggest you access this summary paper:
http://www.newyorkfed.org/research/current_issues/ci2-7.pdf The Fed’s correlation suggests that if the spread decreases to 0.22 % (almost flat yield curve), the probability of recession climbs to 20 %. This value was extracted from a table published in the referenced paper. Recently, in applying that model from 1960 to 2010 the NY Fed calculated 11 recession signals. All 8 recessions recorded in that timeframe were correctly identified. However, three false signals were triggered. Nothing in the econometric modeling arena is perfect.
I personally check this single parameter Fed model at least on a weekly basis. The requisite data are commonly available in any daily newspaper’s financial section. It is yet another excellent illustration of Occam’s Razor in action.
Of course none of these methods and techniques are flawless. Since some residual uncertainty always remains, I make my equity/fixed income mix adjustments incrementally over time and more energetically as the probabilities depart from the threshold 20 % recession probability tipping point that I established for my purposes based on the referenced study. You get to choose your own tipping point.
The overarching goal is to control and mitigate risk. This approach will attenuate the downside dangers that are always present and ready to take a huge bite from end wealth accumulation. The simple mathematics are such that recovering from any percentage loss requires a yet higher percentage gain. Investing is never easy, so…….
Simplicity is always good.
By the way, current application of the techniques outlined in this submittal (even the more complex formulations) conclude that the probabilities of a near-term recession are low, single digit. That’s comforting given the declining economic indicators and the exacerbating nature of recent market performance. But none of these techniques are foolproof.
Best Regards.
Comments
First, thank you for helping keep our brain cells/snynapses attempting to operate in an efficient manner.
Second, you and others may likely be able to rip away what I write here, as I am attempting a mental stimulation excercise for my medical rehab; as it is now determined that a local school official during a recent meeting successfully infected several of us with some type of 24 hour flu cootie which caused high body temps and allowing one to determine each and every aching muscle fiber in the human body from the ears to the very ends of our toes. I will not and can not provide a guarantee of any statement or thought I attempt to write here as being a clear and concise thought process.
Per as section of your write....." A tight correlation exists between corporate profits and GDP growth rate. So, if GDP growth rate could be reliably forecasted, then tightly-linked market movements could be accurately assessed. The simplest definition of a recession is two consecutive quarters of negative GDP growth rate. Therefore, if we can reliably project an upcoming recession, we can anticipate poor equity market performance."
While one may not argue against the more simple charts of moving averages and related; I have considered over the past 3 years as to whether some of the other "old" and known coorelations have become perverted by the many interwoven pulls and pushes of a very chaotic economy. I do believe this is another area of the "new normal". While corp. profits or lack of may indeed benefit equity holdings, I am not so sure that the relatinship to GDP is totally valid.
Many corp. profits have come about with a rework of the business model. Hire as full time, only the most critical employees for one's company. Many others have been and will continue to be part time workers without benefits now or in the future. All of this will continue to rework social models going forward. Many of this part time work force is and will remain behind in wages and continue to be burdened with debt payments that will have little extra monies placed againts a pay down of the debt.
SO, I don't think some models of investing relationships are as valid as in the past. While a corp. may have a lot of cash on hand, I don't know that this will be a profit of value.
I choose to be an optimist; but continue to find myself a "devils advocate" with personal investments and all related. I have, and I believe all should be their own "devils advocate" in all things. One must be able to justify, at least related to our discussions here and/or explain to a friend why such and such an investment sector suits one's needs. It does not mean an investment sector is right for another, but one sure should be able to explain to one's self "why do I have this investment and for what reasons?".
I recall speaking back to the tv and some of the talking heads in late 2008 and early 2009 about their theories "of everything will be alright, this is like the recession of the early 1980's." Well, much of that was so much BS.
This continues to this day with too many of the so-called educated "money pros" on the tv and in print/internet form.
I will continue to believe that too many of these folks do not leave their computer program models, or their ivory towers and continue to attend meetings and related with their own kind and never step foot into the "real world". Many are not less isolated and insulated from the real world than those of the giant banking world, too many U.S. companies and many in our congress; including states and local levels "deciders".
I feel at least 10 more years of time will have to unfold until enough are convinced that this is not and will not be my grandparents or my parents economy (I am 63).
The old, 2 x4 plank to the side of the head to awaken some continues to require a much larger device.
Sadly, as I have stated before; our dear country is too full of ignorant and uneducated in the most simple of "the chores of life on a daily basis". The country has become and continues to be too fat and lazy. My generation is at as much fault as any other for this problem.
Leading indicators and my insights. You/et al may choose to argue any of my thoughts here and this is requested.
I AM NOT the sharpest knife in the rack, EXCEPT at this house !!!
The great industrial revolution of this country started in earnest, according to my views about 1850. For Michigan, the inflow from all parts of the world for employment and a better life started near the same time period with the harvest of the great timber lands. Mining in the Upper Peninsula of copper and iron fueled the on going need for industrial expansion; then the auto industry and all related to it.
One may follow, up to this very date; a wonderful overview of a mutli-facted agri/industrial state in many different areas and establish movements and trend lines in the ebb and flow of events.
I must suspect that the very nature of my ongoing past and present observation and views of the daily changes has colored what I think I see, feel and know.
The big industrial shifts were taking place during a period from 1985-1990 in this state and I believe reflected what was coming.
A kinda summary: Reality and realizations to cause shifts in planning and policies of many things private (folks), public (companies, public institutes, state/local gov'ts) and at a federal gov't level take many years before appropriate actions may be taken to "ADJUST" and if the adjustment is via rules/laws changes; one may expect more years for the details to "show their true face").
The UNWIND continues..................................
OK.........I know there is/was more; but I am out of steam...........time for another recovery nap.
Thank you again, MJG.
Take care of you and yours,
Catch
Thanks for your thought-provoking commentary.
Blowing off steam is one of the main benefits of active websites.
I share many of the concerns and doubts that you so eloquently expressed. I am by nature and by my training a constant worrier. Fortunately, I am also an optimistic fellow; the glass is almost always half full for me.
My most pressing concern about our National wellbeing is what I perceive as a dearth of mathematical skills among all our folks, both young and old alike. You talk mathematics to anyone these days and their eyes glaze.
That’s especially why so many of my postings are statistics and probability theory heavy. I truly believe everyone has the capability to learn these subjects and would greatly benefit from that knowledge. So the educational process on that matter is my self appointed duty and assignment.
I know I bore many Forum members, but I am resolved to accomplish my mission.
Heaven help all of us.
Best Wishes.