jTAM Update August 2011

8/4/2019 jTAM Update August 2011

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Where are equity markets heading?

A tactical BUY opportunity for Global

Equities?

The evidence from mean-reversion modelling

From:

John P. Cuthbert BA, MA, MSc

Independent Financial Economist

August 26, 2011

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


2/15

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Overview

This our latest update following our last in March 2011. It is based on data for the week

ending 19/8/11.

As with earlier work, this analysis seeks to demonstrate that a great deal of asset pricingbehaviour can be meaningfully described as mean reverting.

These mean-reversion phenomena exhibit:

Distinctive statistical characteristics (such as auto-correlated trends, and/or clearprobabilistic boundaries at the extreme);

They are usually associated with real-world business cycle events; And, most importantly, using this analysis it is possible to identify profitable market timing

opportunities and also to think about the statistical signals in conventional strategic terms.

Our approach essentially follows the idea that forecastable events can be conceived of as

probability bounded sets of risk and return correlations. In practice, because asset pricing is

multi-dimensional, no one screen is reliable. Instead, we use a combination of models (2

Mean Reversion, 2 Moving Average, 1 Information Ratio, 2 Expected Return, and a Risk model)

to stress-test the reports of different indicators, and to build an asset pricing picture that

captures as much information as possible.

This approach has a telling forecast record. In our August 2010 update, for example, we

pointed out that equity markets had entered a new mean-reversion phase, and in November

2010 we reiterated that even though this mean-reversion phase exhibits strong return out-

performance, statistically it is not the sort of pricing phase that can be associated with a bull

market.

Rather it marks the end of the Recovery phase in the business cycle when markets wrestle

with uncertainty about the sustainability of economic growth. In a normal cycle this phase

ends with a sharp equity sell-off, and then transitions to a more stable pattern where trending

and rotational behaviour rather than mean-reversion are more common.

Indeed in our last update we were looking for this negative mean-reversion phase (in which

equities are under pressure) to end in H1 2011 and for markets to transition to a different

type of pricing phase, albeit one greatly dependent on economic newsflow.


3/15

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A brief recap of recent signals

In a normal business cycle, the transition from the Recovery phase to the Mid-Cycle phase

has a very definite statistical imprimatur in mean-reversion terms, though it can appear very

noisy using standard technical analysis techniques. This time round, even the mean-

reversion measures were very noisy.

In our last note, for example, we reported that a buying opportunity lurked ahead following a

sharp sell-off. This juncture appeared to arrive (earlier than expected) in mid-March, but we

decided not to signal that as a BUY opportunity because our other screens (which we use to

confirm the mean reversion signals) were not consistent with this being a market low. Equity

markets did however bounce at this juncture but, after a 6% relative to Sovereigns move, the

rally petered out in early April (see chart below)1.

Strangely, our leading Equity/Sovereign Bond model repeated this behaviour in mid-June.

Once again Global Equities bounced around the same mean reversion level as in mid-March,

and once again the pro-equity bounce petered out after a few weeks (and a sharp 5% relative

return move).

Looking at the statistical behaviour of markets reveals a great deal about the strength of the

underlying trend, but most importantly of all, behaviour of this type is crucial for generating

the signals from our forward looking models.....

1The chart captures the drift term in a standard mean-reversion equation. The drift term is one of two properties in our

Ornstein-Uhlenbeck approach (its a common mistake to think of mean reversion as just one variable), and might be thought of as

expressing the trend. In the chart the statistical signal is converted into a relative return.

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relativereturn%

FTSE World vs Global Govt Bonds mean reversion drift

From this mean

reversion level equities

attempt to rally twice

in 2011


4/15

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For example, one way of estimating the forward performance implications of the statistical

behaviour captured in the mean-reversion models is to use an Information Ratio (IR) model.

The IR is a special type of moving average (so it captures trend behaviour), and although we

also use moving average techniques, the IR is particularly useful because it is expressed in

standard deviations, and so as magnitudes approach the limit of what is normal variation the

probability of a turning point ahead becomes much more pronounced.

Through the early part of Q2 2011 the main Global Equity/Sovereign Bond IR model was

signalling an IR bottom ahead consistent with the ending of the current mean reversion

phase (or Recovery phase of the business cycle), and events seemed to be unfolding in a

fashion not dissimilar to the transition to the mid-Cycle phase in the last business cycle (2004-

2005).

(In the chart below, the blue trend line is the historic IR trend, and the red trend line is a

week-by-week 12 week forward forecast.)

But these IR or moving average models are dynamic models, and they change or evolve as

the underlying mean-reversion models capture important statistical events in the underlying

price movements of the Global Equity and Global Sovereign bond indices2. The two failed

equity market bounces shown in the earlier mean reversion screen are a case in point. The IR

model can tell us something about the forward implications of such pricing behaviour, and the

main effect of these events on the IR forecast was that by mid-July the IR forecast signal had

been transformed into something much more portentous (see overleaf).

2They actually capture a complex mix of stochastic and exponential phenomena.

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tandarddevia

tions

IR (52W)

IR (36W) projected

FTSE World vs. Global Govt Bonds Information Ratio trend & trend forecast

In mid-June The IR 'mean-

reversion' model is forecasting a

phase low in September 2011, and

at a roughly similar level to the low

at the same juncture in the last

business cycle.


5/15


6/15

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Current Mean Reversion signals: Is this a BUY for Global Equities?

We have, of course, had a sharp correction In Global Equities but markets have not reached

the levels implied in the IR forecast model. So the issue is: Do equity markets have further

downside?

One way to think about an answer to this question is to look at how Oversold Equity markets

are relative to their history. Thats captured in the chart below.

The current analysis indicates that Global Equities are not only more deeply Oversold than

after last years sell-off, in standard mean reversion terms (namely the normalised

probabilistic relationship of recent returns with an appropriate moving average), Global

Equities are more Oversold than at any point in the last 20 years or so.

Does this make sense?

Even if the US and European economies are heading for recession, the mean reversion mapabove suggests that recent market events have priced something much more dramatic. In

essence, equities have already priced a Crash type event, and even though the IR model

points to more downside, the mean reversion screen above is telling us that this is not likely.

Indeed, as can be seen from the chart, in the two most comparable episodes of the last 10

years (LTCM and 9/11) equities subsequently experienced a very sharp technical bounce.

However, as was the case post the Lehman Bros bankruptcy, such a bounce could prove to be

just a tactical event. We will only know the longer-term path for equities as we observe how

any bounce evolves over the next few weeks. Importantly, equities have to breach the failed

mean reversion limits of March/April and June in order for the IR measure to signal bettersustained prospects for equities ahead.

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standarddeviations

Global Equities vs. Global Govt. Bonds mean reversion screen (1993-2011)

jTAM Normlized Active

Rtn 52W

Equities are more Oversold (in relative

probability terms) than any point in last

20 or so years!

LTCM

Post TMT Bubble

Crash

Post Lehman Bros

Credit Crunch


7/15

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Looking for Global Equities BUY signal confirmation

The preceding analysis indicates that there is a high probability of a sharp technical bounce in

Global Equities. This is obviously a big call, and requires high confidence.

From a forecast point of view, one way of reinforcing our forecast (rather than just relying onmean reversion probability) is to build confidence by attempting to reconcile the signal for

Global Equities with the presence of two further elements.

A bottoming and turning in the forward IR signal for Global Equities vs. Govt Bonds (whichwould gesture that markets have already reached an important low);

A confirmation that a similar signal is also present on a wide range of other asset classes.In this first regard, the current IR signal is hinting at a turning point, and were we to add in this

weeks current market bounce, then the up-turn would look more prominent in the chart

below.

More broadly, that is in regard to our second source of confirmation, a number of key markets

(FTSE Brazil, China, India, FTSE Europe, Topix) and asset classes (UK Small vs. Large, Europe

Small vs. Large, and Russell 2000 vs. S&P 100) are already exhibiting turning points in their IR

signals.

Indeed, as the chart example overleaf testifies, a number of asset class IR forecasts are now at

Lehman Bros Credit Crunch crash levels (Euro vs. SWF, S&P Mid-Cap vs. S&P Large-Cap, Russell

2000 vs. S&P Large Cap, and MSCI Brazil)! If there is no recession in the US/Europe, and

certainly no Crash event, then these models indicate that markets are simply excessively

pessimistic!

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Global Equities vs. Global Govt Bonds current Information Ratio trend and

forecast IR trend

IR (52W) IR (36W) projected Forecast IR is hinting at a bottom,

suggesting a turning point has been

reached.

Current IR

level


8/15

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Such analysis suggests markets are at a significant juncture. The fulfilment of such a sharp

downside projection in the IR signal for the Russell 2000 (as with equities generally) will

require a Credit Crunch type event to drive markets to these levels. In contrast, because the

IR forecast is exponentially weighted, if equities were to bounce for several weeks, then, the

sell-off signal would contract sharply and would confirm that recent market behaviour has just

been too pessimistic! Thats what the mean reversion models are suggesting will happen.

In this regard, the IR signal for Chinese Equities which has long been the leading indicator of

the leading indicators, also signals some hope on a longer term view.

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Russell 2000 vs. Global Govt Bonds IR trend and forecast trend

IR (52W) IR (36W) projectedRussell 2000 IR signal

bottoming

downside

potential

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Shanghai Composite Information Ratio trend and forecast IR trend

IR (52W) IR (36W) projected

Chinese equities forecast to

bottom at a less distressed level


9/15

9

According to the chart overleaf, Chinese A Share markets are experiencing a more typical

cycle-based mean reversionary pricing pattern; the forecast IR low is both lower, more

imminent, and the incipient signal of an expected bounce is also visibly stronger (consistent

with an imminent ending of monetary easing, an inflation peak, or stronger economic data).

A forecast low in Chinese equities (presaged on a change in Chinas economic tempo), pre-

figures a better period ahead for Global Equities (namely something beyond a tactical event).

That might appear to be something of a long-shot given the weight of current economic and

credit problems, but the same prospect is also visibly present in the IR model for Indian

equities.

Importantly, in contrast to the Chinese equity A Share market, the above IR trend chart for

Indian equities pre-figures the end of a major mean-reversionary pattern (it stretches back to

mid 2010 coincident with the peak in the cycle and subsequent policy tightening). So India is

behaving a little differently from China, but crucially, both markets are indicating that a turn in

the IR performance trend has been reached!

This evidence helps to build confidence in the tactical BUY signal on Global Equities (because

cycle driven mean revisionary phenomena attend to be more predictable and so are less likely

to be associated with forecast error), but given that both markets are driven by local drivers

(rather than credit events), a contiguous bounce would more likely have sustainable legs.

That would point to a better and more sustained improvement in the outlook for Global

Equities beyond that suggested by our current tactical call. (A similar signal is in place for the

MSCI Brazil, but the forecast turning point is much lower and later implying a less favourable

tactical outlook for Brazilian equities, but a prefigured end to the Brazilian equity bear market

relative to Sovereigns nevertheless lies ahead.)

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standarddeviations

MSCI India (vs. Global Govt Bonds) Information Ratio trend & Forecast

trend


current level

Indian equities forecast to bounce at same

juncture as Chinese equities


10/15

10

Looking for further confirmation....

Another useful measure of signal confirmation can be divined in the behaviour of Consumer

Staples relative to Cyclicals (in this case the MSCI Industrials index).

As the chart above makes plain (its a mean reversion chart expressed in relative return

terms), Global Consumer Staples have only been as stretched as this relative to Global

Industrials once in the last 10 years or so! That implies a better performance outlook for

Global Industrials, indeed the mean reversion trend model implies a 25% total return bounce

from here if Industrials reach the top of their mean reversion range.

Another plausible area of confirmation for the tactical signal on Global equities is the

behaviour of a defensive haven, namely Gold.

Its difficult to get a complete read across for Gold relative to other asset classes (in part

because futures markets behave differently to spot prices), but even with this caveat in mind,

looking at how Gold has been trading is a reminder that A further sell-off in equities is not the

only potential risk in the current environment.

Gold is now trading at the limits of its normal mean-reversion range (i.e. the distance from an

appropriate moving average), and as the mean reversion chart overleaf makes clear, a sea-

change in risk conditions and a full mean-reversion correction in Gold would imply a 21% sell-

off)!

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T

08/09/2000

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22/03/2002

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13/06/2003

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15/04/2005

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07/07/2006

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T

31/07/2010

relativereturn%

MSCI Consumer Staples vs MSCI Industrials mean reversion drift (2002-11)

superdetrended active cumul

Global Consumer Staples

approaching Lehman Bros

Overbought levels

OVERBOUGHT

OVERSOLD


11/15

11

But perhaps the most important confirmatory message from the mean reversion models is

that Sovereigns have only been this Overbought four times in the last 20 or so years (see chart

below). Indeed in the three episodes most similar to recent events ringed in the chart below

(Sep 98, Sep 01, Jul 02), in all three cases, Sovereigns then reverted sharply to the bottom of

their mean reversion ranges.

-20

-15

-10

-5

0

5

10

15

20

To2

0/12/2002

To2

1/02/2003

To2

5/04/2003

To2

7/06/2003

To2

9/08/2003

To3

1/10/2003

To0

2/01/2004

To0

5/03/2004

To0

7/05/2004

To0

9/07/2004

To1

0/09/2004

To1

2/11/2004

To1

4/01/2005

To1

8/03/2005

To2

0/05/2005

To2

2/07/2005

To2

3/09/2005

To2

5/11/2005

To2

7/01/2006

To3

1/03/2006

To0

2/06/2006

To0

4/08/2006

To0

6/10/2006

To0

8/12/2006

To0

9/02/2007

To1

3/04/2007

To1

5/06/2007

To1

7/08/2007

To1

9/10/2007

To2

1/12/2007

To2

2/02/2008

To2

5/04/2008

To2

7/06/2008

To2

9/08/2008

To3

1/10/2008

To0

2/01/2009

To0

6/03/2009

To0

8/05/2009

To1

0/07/2009

To1

1/09/2009

To1

3/11/2009

To1

5/1/2010

To1

9/03/2010

To2

1/05/2010

To2

3/07/2010

To2

4/9/2010

To2

6/11/2010

To2

8/1/2011

To1

/4/2011

To3

/06/2011

To5

/08/2011

totalreturn%

DJ UBS Gold ETF: mean reversion drift


Gold is trading at the limits of its

normal mean reversion range . A

correction to the bottom of its range

would imply a 21% sell-off!

OVERBOUGHT

OVERSOLD

-30

-20

-10

0

10

20

30

40

To2

8/05/1993

To1

2/11/1993

To2

9/04/1994

To1

4/10/1994

To3

1/03/1995

To1

5/09/1995

To0

8/03/1996

To2

3/08/1996

To0

7/02/1997

To2

5/07/1997

To0

9/01/1998

To2

6/06/1998

To1

1/12/1998

To2

8/05/1999

To1

2/11/1999

To2

8/04/2000

To1

3/10/2000

To3

0/03/2001

To1

4/09/2001

To0

1/03/2002

To1

6/08/2002

To3

1/01/2003

To1

8/07/2003

To0

2/01/2004

To1

8/06/2004

To0

3/12/2004

To2

0/05/2005

To0

4/11/2005

To2

1/04/2006

To0

6/10/2006

To2

3/03/2007

To0

7/09/2007

To2

2/02/2008

To0

8/08/2008

To2

3/01/2009

To1

0/07/2009

To2

5/12/2009

To1

1/06/2010

To2

6/11/2010

To1

3/05/2011

Global Govt Bonds vs. Global Equities mean reversion drift (1993-2011)


Similar mean reversion tops to current position

current

position


12/15

12

Caveats...

Taken together, this looks like strong confirmation for a tactical BUY signal on Global Equities.

But a high probability of a technical or tactical bounce in equities is not the same as saying

that a new mean reversion phase has been reached for equities (implying sustained equity

out-performance).

Moreover, there are two key caveats that suggest that any BUY recommendation should be

limited to a tactical perspective. For a more longer-term positive view on Global Equities to

prevail will require more evidential support. The two caveats are:

The risk models forecast further risk upside; The Global Govt Bond model points to a further bounce in Sovereigns in the months ahead.

Caveat 1: Elevated risk

As the chart below indicates both the risk trend (blue line) and the forecast risk trend-line

(red) have turned up sharply. As risk expands the probability of a sharp sell-off rises.

Equally, a continued rise in volatility implies a deepening bear market with further substantial

sell-offs likely! During a normal business cycle risk should not only be trending down (or flat),

it should also be at a lower level. That implies that a decline in the forecast levels of volatility

is a necessary condition for a return to a more normal asset pricing environment or more

normal conditions for the mid-cycle phase of the business cycle! So as things stand, the risk

model is a major worry, but as with the mid-2010 sell-off, where risk rose sharply then fell

away, we conjecture that a characteristic of this cycle will be that risk will tend to transition

(consistent with a normal cycle) but then be punctuated by violent episodes of spiking risk

(consistent with the pricing of something out of the normal).

0

5

10

15

20

25

30

35

40

45

50

To2

0/12/2002

To2

8/02/2003

To0

9/05/2003

To1

8/07/2003

To2

6/09/2003

To0

5/12/2003

To1

3/02/2004

To2

3/04/2004

To0

2/07/2004

To1

0/09/2004

To1

9/11/2004

To2

8/01/2005

To0

8/04/2005

To1

7/06/2005

To2

6/08/2005

To0

4/11/2005

To1

3/01/2006

To2

4/03/2006

To0

2/06/2006

To1

1/08/2006

To2

0/10/2006

To2

9/12/2006

To0

9/03/2007

To1

8/05/2007

To2

7/07/2007

To0

5/10/2007

To1

4/12/2007

To2

2/02/2008

To0

2/05/2008

To1

1/07/2008

To1

9/09/2008

To2

8/11/2008

To0

6/02/2009

To1

7/04/2009

To2

6/06/2009

To0

4/09/2009

To1

3/11/2009

To2

2/01/2010

To0

2/04/2010

To1

1/06/2010

To2

0/08/2010

To2

9/10/2010

To7

/1/2011

To1

8/3/2011

To2

7/05/2011

To5

/08/2011

To1

4/10/2011

varian

ce

Global Equities vs. Global Govt Bonds risk trend and risk forecast trend

historic variance

(rolling 52W)

forecast variance

(rolling 36W)

Risk turns up and is

forecast to keep rising


13/15

13

Caveat 2: A message from Global Government Debt

As we have observed, Government Debt is massively Overbought on our mean reversion

models, but in balance-sheet recessions of the type being experienced in the US and Europe,

Sovereigns can remain Overbought for sustained periods of time as the yields of even longer-

dated bonds trend to zero. Indeed, even though the recent equity sell-off bears a closer

resemblance to previous crash episodes rather than the post-Lehman Bros bankruptcy, the

2008 episode reminds us that the transition from Overbought (as Bonds were in October

2008) to a sustained under-performance trend in Government Bonds (which they became by

mid-2009) can be a rocky one.

In this regard, the current IR signal on Global Govt Bonds Asset Allocation model (namely in

comparison to itself) deserves a little attention.

Such a signal (because it is exponentially weighted) is very dependent on incoming data, but

as things stand it is a reminder that there are many potential perils for Global Equities to

overcome ahead before it is wise to call an equity bounce in the West anything more than a

bull bounce in a bear market.

-2

-1

0

1

2

3

4

To2

0/12/2002

To2

8/02/2003

To0

9/05/2003

To1

8/07/2003

To2

6/09/2003

To0

5/12/2003

To1

3/02/2004

To2

3/04/2004

To0

2/07/2004

To1

0/09/2004

To1

9/11/2004

To2

8/01/2005

To0

8/04/2005

To1

7/06/2005

To2

6/08/2005

To0

4/11/2005

To1

3/01/2006

To2

4/03/2006

To0

2/06/2006

To1

1/08/2006

To2

0/10/2006

To2

9/12/2006

To0

9/03/2007

To1

8/05/2007

To2

7/07/2007

To0

5/10/2007

To1

4/12/2007

To2

2/02/2008

To0

2/05/2008

To1

1/07/2008

To1

9/09/2008

To2

8/11/2008

To0

6/02/2009

To1

7/04/2009

To2

6/06/2009

To0

4/09/2009

To1

3/11/2009

To2

2/01/2010

To0

2/04/2010

To1

1/06/2010

To2

0/08/2010

To2

9/10/2010

To7

/1/2011

To1

8/3/2011

To2

7/05/2011

To1

2/08/2011

To2

1/10/2011

st

andarddeviations

Global Govt Bonds Information Ratio trend and IR forecast trend


Sovereign Bond IR trend is in

a strong upward phase, but

the forecast signal suggests a

correction followed by a

bounce


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Conclusion: The bottom line

The key message from our latest mean-reversion modelling update is that Global Equities

have reached a key Oversold level that implies that tactically conditions have improved

markedly. In the three similar episodes over the last 20 years when equities were as Oversold

as this, there was a subsequent strong and sustained bounce in equity performance. On our

mean reversion drift model (see chart page 6), a sustained bounce in Global equities to the

top of its mean reversion range would imply a return of 21% relative to Global Sovereigns

from here (as of 19/8/11).

Its a big call to leave the safe haven of Global Sovereigns and Defensive stocks, so strong

confirmation is required. The strongest confirmation for this tactical' message stems from the

behaviour of other asset markets and asset classes. In particular, our forecast IR signals for UK

Small vs. Large, Europe Small vs. Large, Russell 2000 vs. S&P 100, S&P Mid-Cap vs. S&P Large-

Cap, MSCI Industrials vs. MCSI Consumer Staples, and Euro vs. SWF all are exhibiting tactical

BUY signals.

In essence our IR models (which project more downside on the current trend, where our

mean reversion models are saying that a crucial level has been reached) are suggesting that

the recent equity sell-off was not a pure business-cycle phase driven mean reversion event,

but a Crash type event! Of course, Crash events of this type have a high probability of taking

some time before the Markets concerns are fully resolved, (which is just a way of saying that

that there is a high chance of many sharp bounces and sell -offs ahead before any absolute

statistical clarity can be obtained), but equally it indicates that it will take a substantial Credit

Crunch type collapse to drive equity prices lower from here. A confirmation of a US recession

will not be enough (it appears to be already priced).

The corollary of this is that in the absence of a real Crash, then, equities have substantial

upside, but we think that it will take positive news flow on Q3 US economic data, Fed

intervention, an extension of the US payroll tax reductions into 2012, a reversal of ECB

monetary policy and its successful intervention in capital markets to ensure that our 21%

relative upside forecast for Global Equities can be achieved!

Until such positive news flow is present the BUY signal on Global equities should be

considered purely a tactical or short-term one. Indeed, our IR and Risk forecast models

caution that risk conditions remain elevated and unless these risk conditions change - inthe longer-term there remains a high probability of further sell-offs.

From statistical point of view, a better longer-term outlook for equities will require not only

that any bounce reaches something like the top of its mean reversion range (remember two

attempts to do this in March/April and June failed), but also that any equity bounce conjures a

forecast signal in our IR and Moving Average models that indicates a new mean reversion

phase is about to begin.

In this regard, perhaps the most interesting observation contained in this report is that in

three key BRIC equity markets, two of which are in pronounced bear type phases consistent

with unusual levels of policy tightening (China and India), not only has a cyclical market


15/15

15

bottom been reached on our IR forecast models, if these forecasts are confirmed by

subsequent positive economic news-flow, then, it would register the beginning of a new

positive phase in the BRIC economic cycle.

Its much too soon to make that call with complete confidence, but bear in mind that it is

highly unlikely that such a signal on our models would prove to a be false positive (remember

the BRIC countries are not suffering the aftermath of a Credit Crunch, their problem is

Overheating). The exact trajectory towards and beyond any turning point however is less

certain (our furthest forecast horizon is only 12 weeks), though this will become clearer over

the coming weeks, and it is perhaps a little redundant to add that the imputed importance of

such an event should encourage a close watching brief.

John P. Cuthbert, BA, MA, MSc,

August 26, 2011

jTAM Update August 2011

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