Financial Research - Asymmetrical Risk / Reward
Signals Performance History
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RED BOOM SELL
Orange BOOM Reduce Exposure
- - - - - - - - - NEUTRAL - - - - - - - - -
Blue BUST Increase Exposure
GREEN BUST BUY
US 10Y T.
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The matrix and signals are an indicator of an asymmetry of the risk profile
Boom: The risk to the down side is greater than the risk to the upside
Bust: The risk to the upside is greater than the risk to the downside
We like to keep our model simple, digital and color coded, nevertheless we would like to take this opportunity to explain in more depth the meaning of the colors.
Our risk Asymmetry model when flashing RED means, it is time to reduce risk, and when flashing GREEN means, it is time to increase risk, and exposure in the same asset class.
What does Orange and Blue mean? Get ready to reduce (Orange), or get ready to increase (Blue) risk, in particular:
In asset classes with low implied volatility (like Currencies, US Treasury) an Orange or Blue signal in the past has already shown an extreme Overbought (Orange) or Oversold (Blue) circumstance, followed by a correction/reversal without the signal becoming Red or Green.
In asset classes with high Implied volatility (Single Share, or S&P) in order to have a correction/reversal the signal had to be Red or Green.
The implied volatility in each asset class may change with time although bonds and currencies historically had always lower volatility than equities.
Macroeconomic Analysis of the Factors that Triggered the Risk-on and Risk-off Episodes and the Related Market Corrections and Market Rallies/Recoveries.
Out of 8 events the BoomBust Model predicted 6
1. FEB '20: 35% correction
Signal Red BOOM – Predicted YES
2. OCT '18: 20% correction
Signal Red BOOM – Predicted YES
3. FEB '18: 20% correction
Signal Red BOOM – Predicted YES
4. FEB '16: 20% Rally
Signal Green BUST– Predicted YES
5. AUG '15: 10% correction
Signal Neutral – Predicted NO
6. OCT '11: 20% rally
Signal Green BUST– Predicted YES
7. MAY '11: 20% correction
Signal Orange BOOM – Predicted NO
8. MAY '10: 20% correction
Signal Red BOOM - Predicted YES
Here is the macro, policy, political, economic analysis of the factors that triggered those corrections and/or rallies.
1.FEB 2020: 35% correction - Signal Red Boom:
2. October 2018 - 20% correction – Signal Red Boom.
Predicted the correction using the Nasdaq index. Another major US and global market correction occurred in Q4 of 2018 – October to December – and trigger by three major macro factors: first, evidence of economic slowdown or even risk of stall in China, some weak emerging markets, Europe and even the US; second, risk that the trade war between US and China could escalate and turn also into a tech war; third, the Fed reacting to the risk-off episode of December keeping its dot-plot of 3-4 more rate hikes into 2019-20 unchanged and still expecting to keep on running down the balance sheet of the Fed – i.e. quantitative tightening. There were also additional market concerns: rising risk of a harder Brexit; political and economic noises out of Italy, rising risk of a confrontation between the US and Iran; worries about the tech sector being overvalued and subject to political bashing, greater regulatory risk and risk to be damaged by an escalating trade and tech war between the US and China.
This bear market correction continued for 3 months till the end of 2018. By January 2019 the risk-off went into a risk-on mode for several reasons: aggressive dovish signals from the Fed (no more hikes and stopping the QT by summer) and other major central banks together with another round of monetary, fiscal and credit stimulus from China; evidence from growth data in China, EU and the US that the global economy was improving; and signal – at least until May 2019 – that US and China may be likely to reach a trade deal that avoids a tariff war escalation.
3. Feb 2018 - 20% correction when the Signal Red Boom.
Model predicted the correction. After the two risk-off episodes of August-September 2015 and January-February 2016 the appropriate policy easing and the recovery of growth – avoidance of stall or of hard landing – led to a market recovery that lasted 2 years until February 2018. Even the Brexit shock in June led to market ripple effects that lasted only a few days. While those two risk-off episodes were associated with a global economic slowdown – positive but falling global growth – the risk-on episode of February 2016 to February 2018 were associated – like previous risk-on episodes with a global economic expansion – positive and accelerating growth that in 2016-18 was actually above trend growth. This expansion and risk-on episode and rally in US and global equity lasted two years until February 2018 when another risk off episode and 20% US/Global market correction took place.
Our model signaled a red flag by February 2018 but the actual market trigger for that correction was an acceleration in US wage and price inflation – that had remained low and falling for most of 2017 in spite of accelerating growth – that was explained as the result of the Trump fiscal stimulus in an economy where the unemployment rate was getting towards 4% and where the slack in both goods and labor market was rapidly shrinking. For the first time in a decade markets and investors started to worry that inflation may become soon a bigger problem than low-flation or deflation. Markets remained wobbly through the spring of 2018 as, on top of inflation worries, investors were worried about Italy – as a highly populist coalition came to government threatening even Italy’s participation in the EZ – and about the rising risks of a trade war between US and China. Then till Q4 of 2018 US and global equities moved mostly sideways or recovering part of the losses following the February inflation scare.
4. February 2016 20% rally following a Green Bust Signal.
Model predicted the rally. Another global risk-off episode that led to 10% correction in US and global equities started in January 2016 and continued through most of February 2016 for several reasons: new worries about Chinese hard landing by early 2016 as data got softer again, weak US data, Fed decision in December 2015 to start normalizing rates in 2016 at least four times, new worries about Brexit, collapse in oil prices to below $30 per barrel given a glut of capacity (output boom in shale gas and oil in the US), fall in global commodity prices, weakening EM and a strong dollar weakening EM currencies and the dollar price of commodities.
The correction started to reverse when central banks became more dovish – Fed giving up normalization till the end of 2016, ECB , other EU central banks and BoJ going into QE and negative policy rates, PBOC easing and additional fiscal and credit stimulus in China – and when data for China and US improved so that worries about a hard landing started to fade. Also, the dollar started to weaken leading to a rally in oil, commodities and in EM markets and currencies.
5. August 2015 10% correction when the Signal was in Neutral.
Model did not predict the mild correction. The next US and global correction occurred in August 2015 and lasted two months till September 2015. It was triggered by bad growth numbers for China and worries that China could experience a hard landing. Also QE tapering was over by the end of 2014 and markets started to worry that the Fed would starting normalizing rates by the end of 2015.
Our signal didn’t pick up that August-September 2015 correction as it started with a shock in China that lead to a global risk-off for two months. Worries about Grexit in the summer of 2015 also made global markets more fragile until Greece blinked in the game of chicken with the Troika. The risk off went into risk-on by October 2015 as the China and US/global data showed stabilization following also some macro easing by China and other dovish signals by DM central banks. The 10% correction was reversed in October-December 2015 as growth improved, China’s hard landing risks were reduced and policy dovishness and easing started.
6. October 2011 20% Rally following a Green Bust Signal.
Model did predict the rally. The correction occurred between May and September 2011 and by October 2011 our BoomBust Signal turned into a Green Bust signal. By then a Greek rescue package was in full swing and a debt restructuring was agreed; so the risk of Grexit sharply diminished and thus a risk-on in EZ and global markets started.
The subsequent US equity rally was also supported by better economic growth data – greener shoots – and by the start of QE3 and Operation Twist in June 2012 when the yield on 10 year US Treasuries fell to a 200 year low. Then, starting in January 2013 QE4 replaced QE3 and QE4 was state contingent and continuing until the US unemployment rate were to fall deep enough, initially till 6.5%. The taper tantrum of spring 2013 spiked US bond yields but had a minor impact on US equities as markets soon realized that the Fed would need to postpone the tapering at least until the end of 2013 given the spike in yields and a mild risk-off episode in US and global equities. By the time the Fed started the tapering in early 2014 markets were able to absorb it as the economy was stronger.
7. May 2011 20% correction following an Orange Warning Signal.
Model did not predict the correction. The rally in US equity run out of steam by May 2011 and lead to another 20% market correction (with our BoomBust indicator in the Orange Boom corridor) for two reasons: expectation that QE2 will end by June 2011 and a severe deterioration of the Greek and PIIGS crisis in the EZ that led to a troika rescue package for Greece and then a debt restructuring by the fall of 2011.
8. May 2010 20% correction following a Red Boom Signal.
Model predicted the correction. After the Global Financial Crisis and the sharp fall in US and global equities through March 2009 (about 50% cumulative drop since the October 2007 peak) US and global equities started to rally starting in March 2009 as evidence emerged that the monetary and fiscal stimulus by US and other economies was starting to work as economies were bottoming out and a tentative is sluggish U-shaped recovery was starting; ie “green shoots” of growth were emerging.
The improvement in economies and especially US/global equities was helped in particular by the start of QE1 in November 2008 that continued for 17 months until April 2010. But once QE1 was over market started to get nervous that not enough monetary stimulus was continuing while the impact of the Obama fiscal stimulus was fading too. Thus our BoomBust indicator signaled a Red Boom peak in May 2010 – as QE1 ended that led to a 20% market correction in the next few months. So the macro trigger for that correction was the end of QE1 while growth recovery was still weak and while the Eurozone crisis – starting with the problems of Greece was starting to brew and accelerate. That correction lasted for 2-3 months and then it reversed back to a market rally until May 2011 The trigger for the recovery and then rally was expectations of QE2 by the Fed and an improvement in the US recovery; indeed QE2 started from November 2010 till June 2011.
Other Recent Examples of the Signal Working on Other Asset Classes
Other examples of the signal working for asset classes other than indices of US equities are several. In December 2015 Gold had a Green BUST signal followed by a 30% rally. In October 2018 Amazon had a Red BOOM signal that was followed by a 30% correction that ended up with a bear market in the tech sector. At the level of individual stocks another correct signal was the signal flashing Green BUST on the GE stock in December 2018 that was followed by a 60% rally in this stock.
These correct signals on a wide range of asset classes had their own idiosyncratic elements – way oversold or way overbought assets given market dynamics of melt-up or melt-down – but they were also triggered by broader macro factors. In the case of Gold the risk-off episode of August-September 2015 was followed by a reversal in that correction in October-December 2015. In that episode Gold had been on a bearish persistent trend for a few year and by December 2015 it was oversold; from a peak of $1800 per ounce in 2011 it had fallen to a bottom of around 1080 by December 2015.
It was way over-sold given that repeated risk-off episodes had occurred for years, the most recent one being August-September 2015. The trigger for the rally in late December and early January 2016 was the new risk-off episode that occurred in January and February 2016. Unlike the 2015 that was mostly triggered by worries about a Chinese hard landing the January-February 2016 episode was triggered by renewed concerns about a China hard landing as well as several other factors that caused a mini perfect-storm in the global economy and markets; this perfect storm and the fears associated with it led to a sharp gold rally that lasted about eight months. The risk factors – apart from China hard landing – included the following ones: weak US growth data and concerns about a stall in US GDP growth, the Fed decision in December 2015 to start normalizing rates in 2016 at least four times, new worries about Brexit, collapse in oil prices to below $30 per barrel given a glut of capacity (output boom in shale gas and oil in the US), fall in global commodity prices, weakening EM and a strong dollar weakening EM currencies and commodities.
The rally in gold prices continued even after the risk-off factors faded out for the following reasons. The risk-off turned into risk-on when several central banks decided to ease aggressively given the risk-off shocks. The Fed gave up its previously announced start of rate normalization and stayed on hold till the end of 2016; the ECB, other European central banks and the BoJ went into QE and negative policy rates, the PBOC eased aggressively, etc. The Fed flip-flop and easing behavior (delaying normalization for a full year), in particular, led to a reversal of the strong dollar that had been triggered in 2015 by the Fed announcement that rate normalization above 0% will finally start in 2016 after almost 9 years of zero policy rates. So easy Fed and other central banks together with a dollar weakening starting in early spring 2016 fueled the upward momentum in gold prices even after the triggers of the risk-off episode faded: the narrative became one that in a world of too dovish central banks that were now going from QE into even negative policy rates the attempted debasement of fiat currencies was a good signal for gold prices to rally sharply after having fallen for many years since the 2011 peak.
The Amazon Red BOOM signal in October 2018 has some of the same macro factors as the tech and US/Global equities correction that occurred starting in October 2018. Our equity index signal for a correction was in the NASDAQ as discussed above. But within the tech sector the strongest signal of an over-bought boom stock was Amazon. By October 2018 the NASDAQ and Amazon were subject to correction pressure because of worries about the tech sector being way overvalued after years of rapid price appreciation; the tech sector was also subject to political bashing (the fallout of the Facebook – Cambridge Analytica scandal; Trump bashing Big Tech in general and Amazon in the specific given his disdain of the Washington Post now owned by Amazon head Jeff Bezos; greater regulatory risk for Big Tech as a political backlash against the growing oligopolistic power of the FANG was mounting; and risk to Big Tech to be damaged by an escalating trade and tech war between the US and China. All these factors that were big tech-specific made the correction of the NASDAQ and of Amazon more intense and severe than the S&P500 index.
At the level of individual stocks another correct case was the signal flashing Green BUST on the GE stock in December 2018 that was followed by a 60% rally in this stock. While micro-specific factors were at play such as the GE stock being massively over-sold after severe weakening of its P&L and Balance Sheet had led to a massive multi-year fall in the value of the firm there were also macro-factors at play in triggering the sharp rally of this stock. Specifically, the global risk-off episode of Q4 2018 had led to a near bear market for US and Global equities and within that overall asset class some firms with weaker fundamentals had corrected much earlier and much longer and more severely; one of them was GE. But, since GE was oversold based on our signal, when the change in global macro conditions turned the risk-off of Q4 2018 into the risk-on rally of January-May 2019 the rally in oversold stocks such as GE was much more sharply than overall equities indices. This is a case where micro-factors – oversold stock – interplayed with macro factors – the return of risk-on – in ways that led GE to rally in 2019 much more than overall US equities indices.