Ideas Farm: crystal ball sighting



  • Want to predict short-term economic conditions?
  • Here is a tip to help you
  • Tons of new insight-generating data

Wouldn’t it be great if you could predict where the world’s largest economy was heading? As this article mentioned two weeks ago (Happy First Birthday, May 6), there is evidence that some investment approaches thrive under the right economic conditions.

To recap for the non-forensic devotees of this column (it hurts me like that, I guess this is the majority of readers): periods of economic recovery tend to be a great place for valuable investments and small caps; as an economic cycle enters a growth phase, value and momentum tend to do better; as the cycle ages and slows down, it is strategies based on quality, low volatility and momentum that are most likely to outperform; and when it comes to recessions, again quality and low volatility tend to win. All of this is based on a study by research affiliates.

The smart people of a small cap quantitative company Verdad Capital thinks there is something this allows them to guess what will be the economic conditions which will prevail in the United States in the three months to come. In addition, the indicator they use is relatively simple and easy to monitor, so it should be of interest to private investors as well.

Verdad suggests that the so-called high yield spread is the best macroeconomic forecasting tool in the market and that he is not alone in his enthusiasm. Spread refers to the difference between the interest rate offered by sub-investment grade corporate bonds and the corresponding rate for ultra-safe US Treasury bonds. This is information that is available free of charge for the United States and the euro area from the Federal Reserve Economic Data (FRED) website.

What the spread tells investors is how easy it is for less trusted companies to get their hands on the money. When the spreads are low, it indicates that the money is relatively cheap and readily available. When spreads are high, it suggests the opposite. The great thing is that the spreads are forward looking and based on the judgments of the many players in the fixed income market. This means that the information harnesses the collective analytical powers of some of the smartest forecasters and investors, who also have a lot of money based on their good judgments.

So how do you use this data?

Verdad suggests looking at just two things. First, whether the current deviation is greater or less than the median. And second, whether the gap is narrowing (suggesting growing optimism about the economic outlook) or widening (growing pessimism). High and increasing spread suggests conditions for recession to come, high and low means recovery, low and falling spreads mean growth, while low and rising spreads suggest growth will slow down while inflation should slow down. run high.

A back-test led by Verdad that used the indicator to challenge markets and shift to appropriate asset classes, including commodities and fixed income, produced impressive long-term results. Over the 30 years to 2020, the strategy showed a compound annual growth rate of 14.5% vs. 10.3% for the S&P 500, as well as a maximum decline of 17% vs. 51%. The problem is that implementing such a strategy in the real world would create substantial turnover and all the associated costs and complications.

For private investors, however, knowing about budget background music is always helpful and any tips that offer insight are worth considering.

So where are we now? Spreads in the United States and the euro zone are low and calm. This would suggest that there is growth on the horizon or even the emergence of overheating. Oddly, however, it feels like we are still waiting for the upturn in the business cycle. That said, the equity markets have already extracted a good deal of the rally to the upside.



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