A deceptively simple way to make money in the stock market

In a recent post, David Merkel had a warning about the speculative excesses of the stock market. He cited the tendency of Silicon Valley startups to offer downside protection to investors on their own paper:

Here’s my take. When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails. It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity. Things may not look so good after the cash is used, and expectations give way to reality.

He also found the trend of finance professionals leaving for Silicon Valley disturbing:

We saw this behavior in the late ’90s — people jumping to work at startups. As I often say, the lure of free money brings out the worst in people. In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts. This also tends to happen later in a speculative cycle.

How worried should we about these signs?

Last week, I wrote about how valuation didn`t seem to matter to the stock market until it mattered (see Cheap or expensive? The one thing about equity valuations that few talk about). During the expansion phase of an economic cycle, the main driver of stock prices are economic and earnings momentum. It is only during the recessionary part of the cycle that valuation puts a floor on stock prices.

This framework is similar to the one voiced by David Rosenberg, who wrote that bear markets only occur because of recessions and Fed tightening cycles (via Business Insider). Well, sort of, I would generalize the cause of bear markets as recessions and Fed tightening causing recessions or creating recessionary fears.

Ed Yardeni more or less said the same thing as I did (emphasis addded):

A long expansion is a persuasive argument for buying stocks even though forward P/Es are historically high. Investors are likely to be willing to pay more for stocks if they perceive that the economic expansion could last, let’s say, another four years rather than another two years. The more time we have before the next recession, the more time that earnings can grow to justify currently high valuations.

If a recession is imminent, stocks should obviously be sold immediately, especially if they have historically high P/Es based on the erroneous assumption that the expansion’s longevity will be well above average. Bull markets don’t die of old age. They are killed by recessions.

A simple (and stupid) rule
In that case, we can create a some very simple rule for timing the stock market:

1. Buy stocks during economic expansions
2. Sell stocks as recessions approach

At this point, you may say, "Don't be an idiot, that's like saying buy stocks when they go up and sell them when they go down. Or 'Buy stocks when they go up, when they go down, don't buy them in the first place.'"

How can you forecast a recession?

The key issue is how we can tell if a recession is on the horizon.  Already, the likes of David Merkel are warning about the appearance of speculative froth, which is a sign that we are nearing the top of the cycle.

There are several deceptively simple approaches to watch for a recession. Doug Short has his Big Four Recessionary Indicators, which is a useful framework to use. New Deal democrat analyzes high frequency economic releases (his latest one is here). Neither is flashing recessionary signals at the moment.

Real-time forecast signals

While those kinds of approaches have great value and I use their output to supplement my model results, I find them unsatisfying. That's because you are using coincidental or lagging indicators to forecast a leading indicator. Economic statistics, which get released with a time lag (and may be a coincidental or lagging indicator). On the other hand, stock prices represent a leading indicator. 

This has been the Achilles Heel of macro forecasting, using economic statistics (which are released with a lag) to forecast stock and bond prices (which are forward looking) will inevitably cause you to miss the early warning signs of a recession.

There is a better way. There are continuous real-time signals that can give us clues about expansions and recessions. They are called market prices. Here are the three key assumptions to my model:

1. Economic signals about expansion and contraction are persistent. Once an economy start to lose steam and roll over into recession, it will continue to do so until the fiscal and monetary authorities react (with a long lag). That`s why Doug Short`s Big Four Recessionary Indicators work in forecasting recessions. These kinds of indicators just operate with a lag and you will be long stocks as the economy rolls over.
2. The US economy is an important part of the global economy. US recessions therefore will not occur in isolation, but we will see feedback loops with other parts of the global economy. 
3. There are three major trade blocs in the world: US, Europe and Asia (China). Watching what happens with these three major economies will give you more or less everything you need to know about where the global economy is going. Note that they may not all expand or contract in a synchronized way, however.

That`s why I am a technician. It`s not that I believe that there is anything magic about technical analysis. They just happen to be the right tool to use in the current situation.

From model to buy-sell signals

With those assumptions in mind, here is my deceptively simple way of forecasting the US (and global economy). Use trend following models (because of the persistent nature of economic expansions and contractions) on:

• US stock prices 
• Non-US stock prices
• Commodity prices. 

In particular, commodities can tell us a lot about how global demand is changing at the margin. In the last decade or so, they have been more about Chinese demand as China has become the major user  of commodities. 

Recognizing that the regional economies of the three major trade blocs are not always synchronized, give each of the components of the trend following model signals votes and let them tell you whether the world is in expansion or contraction. 

For investors, buy stocks when the global economy is in expansion, sell (or reduce) stock positions when they are moving into contraction.

For traders, watch for direction of the change of the signal. If the signal gets better, buy stocks. If the signal gets worse, sell stocks.

The proof in the pudding

In short, that has been the basis for my Trend Model. The proof is in the pudding and I have been running an account based on the trading signals of that model since September 2013. The latest report card can be found here. The chart below shows the history of the actual (not backtested) buy (dark blue arrows) and sell (red arrows) signals of the trading model.

The performance of the account has been extraordinarily good and well beyond my expectations. It wasn't just the levels of the returns, which was embarrassingly high, but a number of other qualities:

• The consistency of monthly returns, as the monthly batting average was over 70%;
• The skew in the distribution of monthly returns, which suggests that the strategy is limiting losses while allowing winners to run; which leads to...

• Better than expected risk characteristics in the form of drawdowns as the return to maximum drawdown ratio is an astonishing 5 to 1; and
• The superior diversification effects of the strategy, as returns were negatively correlated to both stocks and bonds.

I would caution, however, that the this strategy has been benefiting from a friendly market environment for trend following models. The US equity market has more or less gone up in a straight line in this period. 2015 is likely to see a choppier market and that`s when this model will get an acid test. In that environment, I would expect that drawdowns will occur more often and be larger, which will lead to deterioration in average returns and the monthly batting average.

I am highly encouraged by these results and I will be monitoring and reporting on the results in the future.


Disclaimer: This blog post is for discussion only and I am not trying to sell anyone anything. I am not currently in a position to manage anyone`s money based on the investment strategy that I am describing. No offering will be done without the proper regulatory filings.