I’ve been giving much thought about the investment philosophy behind the post over at Philosophical Economics about the GTT market timing model. To understand what`s behind his investment philosophy, let`s start back with first principles of equity investing.
The equity claim represent the “stub” claim behind debt, or bond financing in a company and therefore represent greater investment risk. Financial theory holds that higher risk should be rewarded with higher expected (average) return. While equities earn more than bonds, on average, they will be subject to higher levels of risk.
The Philosophical Economics GTT model is a way of mitigating some of the risks of equity investing. When it spots an unfriendly market environment for stocks, it imposes a greater degree of risk control with the use of moving average based trend following models. That way, the investor can avoid the worst of downside risk while capturing upside return.
But what represents an unfriendly market environment? Jesse Livermore at Philosophical Economics defines it as recession, but I have repeatedly said that prolonged bear markets are caused by one of the following:
- War or rebellion causing the permanent loss of capital;
- Recession; or
- An overly aggressive central bank tightening monetary policy.
If we ignore the risk of war and rebellion for the moment, the Jesse Livermore GTT model only addresses a recession risk forecast, but ignores the risks posed by excessively tight monetary policy. His GTT model would have stayed long equities during the Crash of 1987, when the Fed raised rates twice in September to defend the dollar. A proper asset allocation model also needs to consider the effects of central bank policy. Here is where I think I can add value to that modeling framework.
What constitutes an aggressive Fed?
Here is my investor market timing model: If the market environment is friendly, buy and stay long stocks. If it is unfriendly, as defined by moderate or high recession risk or an overly aggressive monetary policy, then use a moving average based trend following model for to better tactically control risk.
The question then becomes, “How do you define an overly aggressive monetary policy?”
If you ask ten economists that question, you will get ten different answers. As a first order approximation, I focus on the Taylor Rule
as a way of defining a neutral Fed Funds policy rate. While the Taylor Rule can have several assumptions in its inputs, the FRED blog
conveniently showed the way by calculating the Taylor Rule rate based on a 2% inflation target and a constant 2% real interest rate.
I began my analysis by downloading the aforementioned target Taylor Rule rate, the actual effective Fund Funds rate from FRED and added monthly SPX returns. As the actual level of the Taylor Rule target depends on input assumptions, I defined three monetary policy regimes as follows:
- Neutral: Fed Funds (FF) within 0.5% of the Taylor Rule target
- Easy: FF at 0.5% or more below the Taylor Rule target
- Tight: FF at 0.5% or more above the Taylor Rule target
Here are the SPX monthly returns under the three monetary regimes. Surprisingly, median monthly returns are higher under a tight monetary policy regime than an easy one, though the worst drawdown occurred under a tight policy regime. This initial analysis doesn’t give us many answers about risk management under different monetary policy regimes.
We see more interesting results if we further segregated the sample to rising and falling Fed Funds within each monetary policy regime. It was not a surprise to see that equity returns are higher when FF is falling than rising, but we can also observe that drawdowns seem to be worse in each category under a tight regime. Moreover, median monthly returns fall monotonically as monetary regime goes from easy to neutral to tight, even when FF is falling. It seems that downside equity risk is heightened under a tight monetary regime.
That observation about the higher risk characteristics of a tight policy regime is confirmed by the following chart showing the % of months the SPX is positive. Within each rising FF or falling FF grouping, a tight monetary regime underperforms its peers.
Market tail-risk and monetary regime
Recall the objective of this exercise is to measure the risk of an investment environment so that we can impose some extra risk controls to mitigate drawdowns. One way of measuring risk is kurtosis
, which measures the fatness of the tails of a return distribution.
Here is the explanation of kurtosis for non-geeks. When kurtosis is 0, it is an indication that a distribution is normally distributed (like diagram A). The higher the kurtosis, the fatter the tails. To give a better real-life interpretation of this measure: A risk-manager at a hedge fund once explained to me that once the kurtosis of an investment strategy gets above 2 or 3, he starts to get concerned about unusual fat-tailed events.
The chart below shows the kurtosis of monthly SPX returns under different monetary regimes. SPX return kurtosis rises as monetary regime changes easy to neutral to tight. It was highest when FF was rising under a tight regime.
In other words, what this analysis tells us is that when monetary policy is tight, the chances of outsized moves are much higher than normal, especially when the Fed Funds rate is rising.
A new market timing model
When I put the work by Jesse Livermore at Philosophical Economics
and my analysis of equity returns under different monetary policy regimes together, we can come up with the following market timing model:
- Use a trend following model to tactically control risk when macro risks are high, which is defined as:
- High recession risk, or
- The Fed Funds rate exceeds the Taylor Rule rate by 0.5% or more
- Otherwise stay long equities.
What is the market timing model telling us now?
Jesse Livermore and I have slightly different ideas of what constitutes recession risk (see my Recession Watch
monitor), but our conclusions won`t be that different in the long run. Currently, recession risks are low (see the discussion in my last post Bullish or bearish? What’s your time horizon?
). As for the monetary policy regime test, the Taylor Rule target rate is about 2.3%, which is well above the current effective FF rate, indicating an easy monetary policy.
Conclusion: The panel is green, investors should stay long equities. The current bout of weakness is only a correction, which can happen at any time and without much reason (as an example, see The Ebola correction? Oh, PUH-LEEZ!
This discussion about corrections does bring up an important caveat to this market timing model. This model is designed for investors who want avoid the kind of large drawdowns that are the result of prolonged bear markets. It is definitely not designed to avoid every single 10-20% correction that comes along. As the above analysis shows, even under neutral and easy monetary regimes, single month drawdowns of about 10% can and do occur.
Equity investors have to be able to accept those kinds of risks, as they just come with the territory. Otherwise if you can’t stand the heat, stay out of the kitchen.