Monday, January 3, 2011

Inflation-Deflation Timer Model 2010 report card

As 2010 has come to an end, I would like to review the record of the Inflation-Deflation Timer Model for the year. The chart below shows the cumulative returns of different asset classes, with December 31, 2009 indexed at 100. The red line represents commodity returns, as measured by the Reuters/Jeffries CRB Index, the black line equities, the S&P/TSX 60, and the blue line the US long Treasury bond. The shaded areas are the signals of the Inflation-Deflation Timer Model, as disseminated in previous Trend Watch publications.

Inflation-Deflation Timer Signals and Asset Returns

Correctly long risky assets in 2010
The Model's record in 2010 wasn't perfect but it wasn't bad either. For all of 2010, it correctly remained long risky assets, either in the form of equities or the higher beta commodities, and those assets had positive returns for 2010. The grey areas were “inflation” signal periods, which would have moved the model portfolio into commodities, and the white areas were “neutral” signal periods, which would have moved the model portfolio into equities. The green shaded area represented a period when the Inflation-Deflation Timer Model gave off an “inflation” signal, in which the Model would have normally bought commodities.

Model override turned out to be incorrect
However, I overrode that signal and stayed in “neutral” because of the anomalous condition of rising commodity prices and falling bond yields. It wasn’t until mid-November when bond yields began to rise again that we moved to an “inflation” reading. As it turned out, our model override was incorrect as the Model correctly forecast the outperformance of commodities relative to equities.

In retrospect, I would still have made the decision to override the Model for risk control reasons as commodity and bond markets were giving highly divergent market signals of inflation expectations. At that point, my level of confidence in the model was relatively low. In the words of Jeremy Grantham of GMO, the "true job [of good quants] is to override the model in critical junctures, based on non-numerical factors."

Current signal: Inflation
What is the Model saying now?
Currently, it remains firmly at an "inflation" reading signaling a long position in commodities. As I have written elsewhere, I believe that the intermediate term trend remains up, which means that traders should remain long high beta risky assets. However, we should be prepared for a short-term correction, which should be a good entry point for new cash.

My best wishes for a happy and prosperous 2011.

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