I am surprised that a flood of Forum protest postings did not materialize following my submittal of a single parameter Recession probability Projection (RPP) model. The RPP uses the government bond yield curve as its only independent input parameter.
The reason for my expected Forum blowback was that I included a quote from Albert Einstein cautioning that although simplification is a worthy goal, it must be tempered by not oversimplifying.
Economic and investment markets have been rigorously studied for decades, less rigorously for centuries. More recently, I reviewed Jack Ablin’s “Reading Minds and Markets” which explores the same concepts in a less formal manner. The fundamental goal is to identify and use a few econometric and market indicators to signal broad market direction.
Rudyard Kipling notably said: “ There are 9 and 60 ways of constructing tribal lays, and every single one of them is right!” Indeed.
So there are many ways to skin a cat; there are many ways to forecast market trends. With so many comprehensive models in play there are benefits to be gained with simplification to this 3-ring circus. Therefore, although I reported a one factor model in my earlier posting, I now unveil an expanded Recession Equity Assessment Model (REAM).
In its expanded form, my present REAM also trades on a multi-dimensional analysis to project equity market direction. By only referencing the Fed Yield curve model, I am potentially vulnerable to oversimplification shortcomings.
Most private investors do not have the resources or time that professional money managers can commit. So a practical multi-factor equity market trend model must be less data intensive, less mathematically dense, and less sophisticated then the models used by financial wizards.
I decided to incorporate six factors in my composite recession/market trend model. For each factor, rather than examining a plethora of indicators to characterize each factor, I elected to choose a single metric for that characterization. All the metrics I employ are readily available to all investors. I also elected to construct a weighting scale of these factors with regard to any portfolio adjustments when a directional change is predicted.
The six factors are: (1) Fiscal, (2) Valuation, (3) Momentum, (4) Macroeconomic, (5) Liquidity, and (6) Sentiment (Psychology). A single metric is used to measure the state of each factor with respect to the directional likelihood of the equity marketplace.
The Fiscal factor is considered dominant; the Valuation and Momentum factors are rated primary; the other 3 factors are ranked supplementary. Portfolio realignment percentages are scaled according to these classifications.
The yield curve is the metric used when assessing the Fiscal (1) factor. That’s a precise adoption of the referenced NY Fed model. The only inputs needed are the 10-year Treasury note and the 3-month Treasury bill current yields. If the yield difference between these two bonds becomes less then 0.22 percent, a deteriorating market is signaled. Based on that signal, my equity holdings will be reduced by 20 % and moved to a short duration fixed income product like Vanguard’s Short-Term Corporate bond fund, VFSUX.
The Fed yield model is one of two key mandatory action signals. The other is the Momentum factor to be discussed later. These immediately generate trading activity. The other factors are not acted upon unless one of these two factors penetrate their respective threshold levels.
A primary factor in the model is the Valuations (2) parameter. Is the market underpriced or overpriced? I use the Greenspan-Yardeni Inverted Yield metric for this assessment with a few slight modifications. Instead of comparing the inverted P/E curve for the equity proxy against the 10-year treasury, I use the Barclay 10-year corporate bond yield. I use the average between the S&P 500 Index P/E current and P/E projected ratios as a proxy for the marketplace. When the Barclay yield exceeds the equity yield, the equity market is deemed overpriced. A 15 % portfolio adjustment into fixed income is executed.
The Momentum (3) factor is evaluated by examining the difference between the 65-day and the 200-day S&P 500 Index moving average plots. The momentum metric is a primary factor and controls, along with the Fiscal factor, if the signals from the other four factors will be implemented. If the 65-day moving average penetrates the 200-day data series on the downside, a sell signal is generated. The reverse is actionable on a surging equity market. A 15 % portfolio realignment is executed if this test is satisfied.
The Macroeconomics (4) factor is addressed by recognizing the year-over-year real (adjusted for inflation) GDP growth rate. Historically, US government demographics data support a 1 % annual population growth rate. Therefore, the real GDP growth rate must exceed that level for a marginally healthy economic environment. If the 1 % GDP growth rate is not achieved, a recession and/or poor market performance is expected. If that condition is recorded, a 10 % portfolio reallocation is made into fixed income holdings. The GDP growth rate data is easily accessed on the Bureau of Economic Analysis website.
The Liquidity (5) factor is assessed by comparing the M2 money supply annual growth rate against the most recent year-over-year actual GDP growth rate that includes inflation. If the M2 rate falls below the real GDP growth rate, money is tight and the economy is likely to be constrained. That is a negative scenario. A 10 % portfolio shift downward from equity positions to short term fixed income holdings is dictated. This again is a supplemental realignment dependent upon the direction of the Fiscal and Momentum factors. The St. Louis Fed website provides monthly M2 money supply updates.
Market Sentiment (6) is the final factor in the model. The metric I selected to represent the evasive market psychology is the AAII Sentiment Indicator which reflects the weekly feelings of about 100,000 participating members. I use this as a contrarian’s signal. The data is readily available for free on the AAII website. The model contrasts the current bullish percentage against the historical average. The historical average is about 31 % and changes slowly. If the bullish sentiment exceeds that level, I interpret this finding as a overly optimistic popular judgment. The herd usually overreacts. If the 31 % is exceeded I convert 10 % of my equity positions into fixed income units. Again, this factor is conditional upon the Fiscal and Momentum elements.
That’s it; that’s the complete package. The required data to score the factors is accessible on the Internet. The analyses demand a little research and simple arithmetical calculations.
You probably noticed that the sum of all the portfolio realignments do not total 100 %. That’s by design. I have a firm belief that the market always behaves with residual uncertainty and with worrisome unknowns. Therefore, my portfolio is never completely without some equity positions. If all six factors are triggered in the direction of a market meltdown, I still plan to retain about 20 % of my original equity positions.
Note that the percentages that I quoted in earlier paragraphs pertain to the equity portion of a diversified portfolio.
Today, a scoring of the six-factor REAM formulation all signal no recession and reasonably positive equity market prospects. Therefore, I am presently in a holding pattern. However, some trend lines do not appear promising. I suspect dark horizons, and finding a safe harbor after the storm arrives is sometimes challenging.
I’m sure many of you use more elegant and more sophisticated tools then those that I outlined in this posting. I’m still trying to simplify.