Etienne Hannart - Nicolas Paris

“Minsky phases” a Tactical Asset Allocation model

Financial crises are not a succession of booms and bust in a straight line but are occurring following a

loop pattern.

Essential Minsky idea

1. Debt markets are smarter than equity markets2. Momentum Works3. Economic data matters : it has a predictive power

Other main assumptions

The Minsky Phases or the loop process

Comfort Phase

Speculative Phase

Ponzi Phase

CRASH

Comfort Phase

Minsky Moment

Looking for safe and reasonnable yieldsFinancial Innovation vs new regulations

Seeking AlphaCredit expansion

Beta huntingAsset boomInflation

Identifying the ‘Minsky Moment’

I) Spotting potential ‘Minsky Moments’

II) If one is seen coming :A) First, get out of Risk AssetsB) Then, assess the magnitude of the coming crash –

Should we short or not ?

III) If short Risk Assets, need to find the best point to cover shorts and go long

Model Logic

Indicatorsdetailed

Indicatorsdetailed

Model Logic

I) Recession Warning

II) Short or Not ?

III) Recovery Indicator

1. RationaleAn Inverted Yield Curve is a bad omen Lenders are showing that they have no

confidence in borrowers Minsky « Ponzi Phase » approaching

2. Our Approach Follow the spread of 10y US T-Bonds and 3m

US T-Bills

I. Recession Warning 1 : Credit Spread

I. Recession Warning 1 : Credit Spread

I. Recession Warning 2 : Monetary Growth

1. RationaleMoney Supply growth acts as a proxy of money

availability Second component of « Minksy moment »

Money must be expensive AND scarceNegative monetary growth shows credit

destruction

2. Our ApproachWe wait for a negative CPI adjusted monetary

growth

I. Recession Warning 2 : Monetary Growth

I. Recession Warning : Combined signals

If the two indicators give signals on the same month, we get a «Recession Warning».

As we have simultaneous signals, we consider the recession warning received to be strong, so we extend it over the following 2 quarters.

Recession Warning Sell Equities, Buy T-Bills

I. Recession Warning

Sell Equities, Buy T-Bills

No false positives, no recessions missed after 1962.00’s one is spotted a tad too late

Model Logic

I) Recession Warning

II) Short or Not ?

III) Recovery Indicator

II. Short the Recession ?

1. Rationale For precise timing, listen to markets Debt markets are smarter than Equity markets Momentum has a predictive power

2. Our Approach We compare the momentum of

S&P-500 US T – 10y

II. Relative Strength - Results

Bond relative strength Sell Short Equities, Hold T-Bills

Interpreting the indicator is very simple : if it shows that bonds are stronger than equities during a recession warning, then the model sells short the S&P-500. All other signals are ignored.

II. Relative Strength - Results

Final ProjectIE Business School December 9, 2010 – xx/yy

Many false positives, all filtered by the recession warnings.

Mild recessions do not trigger shorts

Model Logic

I) Recession Warning

II) Short or Not ?

III) Recovery Indicator

III. Unemployment Growth

1. RationaleUnemployment is the most important

macroeconomic data for the marketsTight relationship between recession through

and peak in new claims for unemployment insurance (Robert Gordon)

2. Our Approach Use the smoothed slope of unemployment,

pinpointing its reversal

III. Unemployment Growth

The slope reversal always happens between the middle and the end of the recession

III. Industrial Supply Management (ISM)

1. Rationale Encompasses most of the real economy

(employment, inventories, new orders) Widely followed Serves as a confirmation of the employment signal

2. Our approach The ISM gives a very noisy signal, so we use a simple

system based on two tresholds : One far below (“So bad that it has to get better”) One above (“Already recovering”)

III. Combined signals

When both the unemployment rate and the ISM index are providing a positive signal, we go long equities again.

Recovery Indicator Signal Cover Shorts / Long Equities

III. Combined signals

All short positions profitable, except the first one (1970)

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Short S&P 500 periods

System is Short

SP-500

Performance Review

Decision ProcessAlgorithm

10y/3m spread

Credit Growth

YES

YES

SELL EquitiesBUY T-Bills

Algorithm – a Loop process (1)

Recession Warning

This month & next 6 months

10y/3m spread

Credit Growth

YES

YES

SELL EquitiesBUY T-Bills

Algorithm – a Loop process (2)

Relative Strength

Recession Warning

NO

YES

HOLD T-BillsSELL Equities ShortBUY Equities

Recession Warning

This month & next 6 months

SELL T-Bills

10y/3m spread

Credit Growth

YES

YES

SELL EquitiesBUY T-Bills

Algorithm – a Loop process (3)

Relative Strength

Recession Warning

NO

YES

HOLD T-BillsSELL Equities Short

UnemploymentGrowth

ISM

BUY EquitiesYES

YES

Recession Warning

This month & next 6 months

SELL T-Bills

Performance ReviewLeverage

Leverage (1/2)

• Leverage is dangerous because it makes a portfolio vulnerable to quick drop in equities prices.

• However the main purpose of our model is to limit exposure towards this type of events.

• And it does avoid most recessions • Therefore it is adapted to leverage

Leverage (2/2)

• Use of leverage when E(Rm) > cost of funding• E(Rm) defined by CAGR of S&P 500 from 1950

to current month.• Cost of funding = Risk free rate + 100 bps• Used both when long and short• We use a conservative level of leverage of

1.3:1 (The fact that the model has predicted past recession succesfully is not a guarantee..)

Performance Review

Performance Review

Performance

Decisions & Performance

Closer look at main recessions

LimitsLimits

• Traps of backtesting– Threshold dependancy– Use of monthly returns

• Our approach– A rationale for each indicator– A rationale for each threshold number– Using round numbers– Rules can be explained in plain english

• Objective– Give to potential users the confidence to follow the

system’s recommendations

Guidelines / Methodology

• Recession Warnings– Intrisicaly robust, as it does – Weak to one parameter : number of months of ‘pushing

forward’ the recession warning.• Reducing it punishes the results (quite logically)• Increasing it too (less acceptable)

– Many solutions available, but still wondering over the most intellectually satisfying (rather than the most profitable)

• Short or not– Parameters changes : robust– Weakness : Interaction with Recession Warnings

• Recovery indicator– Parameters changes : very robust– No changes needed

Robustness / Treshold dependancy