Where are equity markets heading?

The evidence from mean-reversion modelling: An innovative approach to Market-Timing and Asset Allocation.

From:

John P. Cuthbert BA, MA, MSc Independent Financial Economist November 22, 2010 john@fundconsulting.f9.co.uk

Introduction Market timing, by common consent, is a tricky often unfathomable business. The majority of investment professionals place little or no store in it. Our approach is very different. It draws on eclectic tools (often from process engineering) and other insights from contemporary research in financial statistics (such as the work of Andrew Lo at M.I.T), and objectively focuses on economic pricing behaviour. Our simple aim is to identify the extent to which and when asset prices contain opportunities that can be exploited. From an empirical or observers point of view, there are two types of market timing effects: short-term and longer-term. As a result we use two different types of models to identify these effects. Perhaps the more interesting of these two types relates to longer-term effects. From a formal point of view, we can say that if asset markets are rational, then they should price macro features. These macro features (as the word itself suggests) ought to be large scale effects, and if markets are also consistently rational, we perhaps should also be able to detect some sort of consistent pricing of macro evidence from business cycle to business cycle. Of course, business cycle asset pricing is a highly controversial area in mainstream economics, but we would simply say that the evidence is more pervasive - and more persuasive - than generally assumed. We present some of this evidence here. Before we launch into that, we ought to first apologise (and perhaps also defend) the use of statistics here. We apply statistical methods - and often non-standard techniques - because we are seeking to identify attributes of pricing behaviour that are not standardly captured by other methods such as stock valuation or rational asset pricing models. Thats how this approach adds value! Some of this statistical work will be unfamiliar, and much of it is complicated. Even so, theres usually an easier way of doing things, and with that encouragement in mind, we offer here an approach that rests on the presentation of simple diagrams (rather than maths) that capture more familiar aspects of market pricing behaviour....

Mean reversion behaviour One of the most important statistical ways of thinking about and capturing asset pricing behaviour is mean-reversion1. Not only is mean reversion a really important area of research, it is also poorly understood, perhaps because it is both diverse (there are many different mean-reversion processes or models) and complex. For example, phases of the business cycle -and different business cycles too - often exhibiting different forms of mean-reverting behaviour (which is one reason why its hard to make standard valuation techniques work consistently). Putting these difficulties to one side, its nonetheless true to say that a good deal of asset pricing behaviour can be meaningfully described as mean reverting. These mean-reversion phenomena exhibit very strong statistical characteristics (such as auto-correlated trends, and/or clear probabilistic boundaries at the extreme), and they are usually associated with real-world business cycle events. This conjunction between statistical and real world events is no small thing; it renders it possible to identify these mean-reversion phases as profitable market timing opportunities and also to think about them in conventional strategic terms. Large scale mean-reversion effects tend to be more describable as trends or phases (shorter-term effects are better described as trading type phenomena) and so they are observably present in Asset Allocation performance behaviour. For example, in comparative Asset Allocation strategies (most obviously between Global Equities and Global Bonds) the strongest mean reverting asset pricing behaviour occurs in three phases: at the end of a business cycle; in the bounce from the bottom of the cycle; and finally in the Recovery slowdown phase. The recent asset pricing (or business) cycle has experienced all three of these meanreversion phases, their magnitudes have been statistically significant (and more than significant in performance terms, and we have constructed statistical forecast models that are able to precisely define their direction and turning points (their length can also be estimated through business cycle comparisons, as we will see shortly). Lets take a look at this recent evidence...

By mean-reversion we mean any variable whose prospective performance potential is proportionate to its distance from an average (in practice we use moving averages of different types), though this relationship may well be non-linear rather than linear. However, mean-reversion trends are actually modelled using a drift term which tends to have stochastic properties.

2010 Mean reversion behaviour Since the beginning of 2010 we have been pointing out that the post Recovery bounce (from March 2009) was coming to an end. We predicted and demonstrated (ably we think) that this phase would come to an end in April, and that subsequently Global Equities vs. Global Sovereigns would experience a typical end-Recovery period mean-reversion in which equities under-perform. That has proved to be the case. There are many ways of statistically describing this type of mean-reversion behaviour2 but the easiest way to present it pictorially is to use an Information Ratio (IR) model. The IR is a special type of moving average, and because it is expressed in standard deviations (i.e. units of variation), as magnitudes approach the limit of what is normal variation, the probability of a turning point ahead becomes much more pronounced. In the IR chart below we have compared the current business cycle to the last business cycle. This is a Global Equity versus Global Govt. Bond comparison so an upward-sloping IR trend line implies equity out-performance and vice versa. As can be seen, the IR trend (or Recovery mean-reversion phase) in the current cycle peaked at exactly the same standard deviation magnitude as the same phase in the previous business cycle (2003-04). This peak occurred in April and confirmed that a new mean reversion phase had begun in which equities would be under pressure relative to Sovereigns until this new mean reversion phase had come to an end.

s 3 t a n d a 2 r d d e 1 v i a t 0 i o n s -1

Global Equities vs. Global Govt Bonds: Two IR mean-reversion patterns, a business cycle comparison

2003-04 and 2009-10 Recovery phases peak at same s.d. magnitude signalling end of equity rally

2/5/03-18/11/05 8/5/09-19/11/2010

-2

We actually use 5 different models with the main mean-reversion model being the Ornstein-Uhlenbeck equation.

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 101 105 109 113 117 121 125 129 133 We are here Forecast

We have also used this IR model approach (supported by our other models) to pinpoint the end of the subsequent equity market sell-off phase, which occurred in late July/early August. In previous business cycles, the equity sell-off phase lasted a similar amount of time, and ended with a bang (a major sell-off) rather than a whimper. For all the talk about New Normal, Double-Dip, and the equity Ice Age, guess what happened this time round?
3

2.5 s t 2 a n d1.5 a r 1 d d0.5 e v 0 i a -0.5 t i o -1 n s -1.5

3 Information Ratio Business Cycle paths (Global Equities vs. Govt. Bonds)
Current Phase

2/5/03-18/11/05 29/10/93-27/1/95 8/5/0919/11/2010

-2

As you can see from the chart, the ends of the post-Recovery mean-reversion phases (little yellow circles)3 have been almost exactly synchronous in each of the last two full business cycles. Julys bottom this year was no different! Although this coincidence is extra-ordinary, it is purely an empirical feature. There is nothing about the structure of the models that should determine such extra-ordinary outcomes, that said,the statistical properties of the behaviour, namely that there tend to be normal statistical limits to events means that as markets approach these statistical limits (in standard deviations), mean-reversion modelling tells us that the probability of change in the trends direction (or mean- reversion) rises. It might have otherwise been so, but everything about this business cycle (from a statistical point of view at least) has pointed to high similarity with previous cycles. And so being able to think and observe in this statistical way has enabled greater clarity about market direction when almost every real world event seemed to have conspired to a different conclusion.

Please note that we have used our main Ornstein-Uhlenbeck mean-reversion model to determine the length of the meanreversion phase, but there are important statistical reasons why this effect should also be mirrored in the IR trend!

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 101 105 109 113 117 121 125 129 133 End of mean reversion phases In previous Business Cycles equity sell-offs have been preceded by a collapse in the IR, and subsequent equity rallies have tended to coincide with a bottom or bottoming in the IR!

Total return impact of mean reversion phases Of course, investment managers dont think in IR and mean-reversion model terms. What really matters is total returns! So in our approach it is important that all signals can be converted into some expected return forecast or general return expectation. In the two previous business cycles the post-Recovery mean reversion phase ended with an equity market sell-off. This sell-off was substantial (which is the statistical effect that drives models to their limits), and if we compare the recent experience to previous cycles we can assess the degree of similarity.
40

30

35

3 Total Return paths associated with mean reversion phases (Global Equities vs. Govt Bonds)

25

30

20
25

15
20 2/5/03-14/10/05 8/5/09-19/11/2010 15 29/10/93-27/1/95

10

5
10

The ends of previous mean reversion phases have been preceded by a substantial sell-off in Equities and this looks to have occurred in the current cycle too! 1 5 9

-5

25

13

17

21

29

33

37

41

45

49

53

57

61

65

69

73

77

81

85

89

93

97

101

105

109

113

117

121

125

129 -10

-5

So the chart above tells us something else about how extraordinary recent events have been. Not only have the lengths of the Recovery and post-Recovery equity selloff phases been similar in length and magnitude when expressed in IR and meanreversion terms, the total return behaviour has been very similar too (see green trend in chart above for the current cycle). We live in challenging and unsettling times. Debt deleveraging, quantitative easing, a volatile business cycle and their unravelling uncertainties will linger with us, and although these events are daunting, mean reversion analysis tells us that none of it is having any fundamental impact on performance behaviour. Instead the most important thing to know about the current cycle is that it is being priced in a similar way to previous business cycles!

2011 Expected Mean Reversion behaviour All this provokes the most obvious and perhaps the most important of questions: what is likely to happen next? We can use the mean-reversion models to answer this question. In the chart below we show the two business cycle comparison again, but this time with the current IR trend and forecast IR trend shown (the current 12 week forecast is the part of the red trend curve beyond the small yellow circle). We can see that in the last business cycle phase (blue trend), although the equity under-performance phase ended in mean-reversion and total return terms at this juncture in the cycle, in IR terms equities remained under performance pressure relative to Government Bonds (the blue trend moves sideways until an obvious bottom from which an obvious strong equity out-performance trend began in 2005). The explanation for this is very simple. The IR is a return/risk ratio, and in 2004-05 markets focused on macro risk (the denominator in return/risk) rather than corporate fundamentals, a form of behaviour which simply reflected the pricing of the transition from the Recovery to the mid-part of the business cycle. Something similar is happening this time round. Simply put, markets have a lot to weigh up with regard to figuring out whether the current expansion can be sustained. Our IR model forecast and 2004-05 comparison suggest that these uncertainties wont be resolved for another 21 weeks (period 81 to period 104 on the horizontal axis). Until then, equities remain at significant risk of major reversals.
2.5

Two IR business cycle paths (Global equities vs. Global Bonds)

2 s t a1.5 n d a 1 r d 0.5 d e 0 v i a -0.5 t i o -1 n s -1.5

IR UNDER PRESSURE

-2

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 101 105 109 113 117 121 125 129 133 We are here In the previous business cycle, the IR trend, though it bottomed, remained under pressure for many more months until a stronger performance phase could begin here.
2/5/03-18/11/05 8/5/09-19/11/2010

Current Risk Forecast Key observations... Our mean- reversion model analysis tells us that the post-recovery phase where equities un-ambiguously under-perform Sovereigns is over. Equities have embarked on a transitional phase (in IR terms) in which, if uncertainties about the sustainability of the current business cycle expansion can be resolved, then Global Equities have the potential to embark on a very strong out-performance phase in 2011. But the transition through this phase depends crucially on risk behaviour. If these observations are sound, then our risk forecast model is crucial for determining current Asset Allocation policy. In the chart below we show the actual relative risk (or tracking error) behaviour of Global Equities vs. Global Govt. Bonds over the last three business cycles (blue trend) versus our risk model forecast (red trend). It is very evident that risk magnitudes can change a great deal but it is perhaps less obvious that in recent months the forecast risk direction has changed significantly. It increased sharply in early 2010 before beginning to decline in August. This type of behaviour has huge ramifications for the pattern of equity/bond returns. Some of our clients have had some difficulty understanding this point from what appear to be small movements in the trend pattern of the chart below, so overleaf we present a more detailed decomposition that sets out the return impact.
50 45 40 35 30 25 20 15 10 5 0
To 28/05/1993 To 01/10/1993 To 04/02/1994 To 10/06/1994 To 14/10/1994 To 17/02/1995 To 23/06/1995 To 27/10/1995 To 08/03/1996 To 12/07/1996 To 15/11/1996 To 21/03/1997 To 25/07/1997 To 28/11/1997 To 03/04/1998 To 07/08/1998 To 11/12/1998 To 16/04/1999 To 20/08/1999 To 24/12/1999 To 28/04/2000 To 01/09/2000 To 05/01/2001 To 11/05/2001 To 14/09/2001 To 18/01/2002 To 24/05/2002 To 27/09/2002 To 31/01/2003 To 06/06/2003 To 10/10/2003 To 13/02/2004 To 18/06/2004 To 22/10/2004 To 25/02/2005 To 01/07/2005 To 04/11/2005 To 10/03/2006 To 14/07/2006 To 17/11/2006 To 23/03/2007 To 27/07/2007 To 30/11/2007 To 04/04/2008 To 08/08/2008 To 12/12/2008 To 17/04/2009 To 21/08/2009 To 25/12/2009 To 30/04/2010 To 3/9/2010 To 7/1/2011 variance (rolling 52W) variance (rolling 36W) forecast

Global Equities vs. Global Govt. Bonds Volatility and Forecast Volatility

Forecast and actual volatility rises in early 2010 before rolling over In August!

Risk Forecast return decomposition The essential technical point to grasp about changing risk magnitude is that small changes can have big implications for the tails of the distribution. Essentially, if Equity/Bond risk is expanding (and the risk number is greater than in previous cycles), and if equities are in an under-performance mean reversion phase, then the drawdowns in the sell-offs will be larger compared to previous cycles. We can see that in the chart below.
8

Global Equities vs. Global Bonds two business cycle return comparison
6

4 % a 2 c t i 0 v e -2 r e t -4 u r n -6

-8

-10

In the chart above we are looking at a comparison of week-to-week Global Equity/Global Govt Bond active return variation for the present cycle (red line) and last business cycle (blue line). Putting aside the obvious similarity, in the circled area we can see that in the current cycle the week-to-week return movements were much more extreme in April-July relative to the same cyclical period in the last business cycle phase, and the negative drawdowns tended to be greater than the positive bounces for equities. From a portfolio point of view, such analysis not only pointed to being underweight Equities relative to Bonds (which was our recommendation in March), the negative skew in returns also pointed to the value of some type of portfolio insurance to protect against equity downside. However, since July, Equity/Bond risk has contracted, and although the change in risk might look modest in the chart on page 8, this, coupled with the sea-change to an equity out-performance phase, has produced a profoundly different pattern of return variation. 9

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 As equity risk expands in JanApril 2010 the magnitude of the return swings at the top and bottom of the return range increases!
2/5/03-13/8/04 8/5/09-19/11/2010

Once again we can see this effect in a business cycle comparison. The chart below repeats the preceding chart, but this time the period of week-to-week active returns from July-Nov this year is compared to the appropriate cyclical period in the last business expansion.
8

Global Equities vs. Global Govt. Bonds 2 business cycle comparison

% a c t i v e r e t u r n

-2

-4

-6 2/5/03-13/8/04 -8 8/5/09-19/11/2010

-10

The chart clearly shows that from week-ending July 9, 2010 the active return performance for Global Equities vs. Global Bonds has had smaller drawdowns (i.e. the extreme negative values in the red line have been smaller than the blue trend, the last cycle) and the positive peaks have also been greater in magnitude. This is a most curious and not well observed development, and one possible explanation for this positive return bias at this juncture is that it simply reflects the impact of a Bernanke put, in other words the fundamental support that QE2 is providing for risk assets!

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 In comparison to Jan-Apr, the pattern of active return variation in July-Nov 2010 has been biased towards more positive values.

10

Current forecasts Where does this leave equities? Main forecast: Equities are in an out-performance phase relative to Global Govt. Bonds. In a normal cycle this pattern will persist even when equities are overbought. All models are predicting this pattern to remain in place, and the bafflingly high correlation with the pattern of previous cycles continues to provide further support for our model forecasts. Main risks: However, IR mean reversion is not entirely complete, which implies that Global Equities are still in a period of high pricing uncertainty and remain at risk of substantial & sustained sell-offs. Indeed, statistically speaking, a period of consistently positive equity returns cannot emerge until this pattern changes. That outcome is more likely when the multiple worries about current business cycle sustainability have been resolved.

Possible sell-offs As things stand, both our IR and Moving Average forecast models are pointing to a great deal of choppiness ahead. Indeed, we should be experiencing now the first equity soft-patch (see the volatile red forecast trend in the chart below), with the next predicted in January 2011. FTSE World vs. Citigroup World Sovereign Bond 52W Information Ratio & IR projected

3
s t a n2 d a r 1 d d e 0 v i a t-1 i o n s -2

We are here

-3

To 28/05/1993 To 08/10/1993 To 18/02/1994 To 01/07/1994 To 11/11/1994 To 24/03/1995 To 04/08/1995 To 22/12/1995 To 03/05/1996 To 13/09/1996 To 24/01/1997 To 06/06/1997 To 17/10/1997 To 27/02/1998 To 10/07/1998 To 20/11/1998 To 02/04/1999 To 13/08/1999 To 24/12/1999 To 05/05/2000 To 15/09/2000 To 26/01/2001 To 08/06/2001 To 19/10/2001 To 01/03/2002 To 12/07/2002 To 22/11/2002 To 04/04/2003 To 15/08/2003 To 26/12/2003 To 07/05/2004 To 17/09/2004 To 28/01/2005 To 10/06/2005 To 21/10/2005 To 03/03/2006 To 14/07/2006 To 24/11/2006 To 06/04/2007 To 17/08/2007 To 28/12/2007 To 09/05/2008 To 19/09/2008 To 30/01/2009 To 12/06/2009 To 23/10/2009 To 5/03/2010 To 16/07/2010 To 26/11/2010 IR (52W) IR (36W) projected

IR forecast model suggests lots of volatility ahead

11

The potential for equity sell-offs also appears to be visible in the cycle on cycle comparison of Global Equity/Bond active returns (shown again below). That pattern also points to a further period of equity weakness ahead and a substantial sell-off in April 2011 if the pattern of cycle-on-cycle correlation holds.

Global Equities vs. Global Bonds two business cycle return comparison

0 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 106 109 -2 -4 -6

2/5/03-13/8/04 8/5/09-19/11/2010

Equity weakness ahead here in JanFebruary 2011

With substantial projected sell-off in late April 2011 if the pattern repeats

-8

-10

Of course, as we have made plain, the impact of such patterns even if the correlation with the previous cycles holds substantially depends on risk variation in this cycle. That is something we shall monitor for our clients carefully on a week by week basis. For now, even with current volatility, all the main Asset Allocation and sector models point to a pro-Equity bias as being the most profitable disposition based on current statistical evidence, and to high beta equities in particular (sustainable growth has a more mixed picture) on a 3 month view.

John P. Cuthbert BA, MA, MSc Independent Financial Economist November 22, 2010

12