One of the things that I’ve heard loud and clear from you, my Lead-Lag subscribers, is that the risk signals, and what this service offers for that matter, can sometimes be less than intuitive. The majority of Seeking Alpha’s marketplace services, and the financial media in general, tend to take more of an explicit “buy this” or “sell that” approach. Since the Lead-Lag Report works more to identify the market conditions that suggest where asset prices could be heading next, it can be fairly different than what you’re used to seeing.
One comment, in particular, on the chat board recently sort of crystallized this notion.
“Almost every 'newbie' question in here is answered with a link to the 4 papers that were authored by Michael. And the introduction page doesn't really say much about how to use the service. I think we need more of a 3 page ‘this service for dummies' page that really explains in more than shallow detail what is going on here.”
First, nobody is a dummy around here! Second, I understand that reading academic research papers can be more of an acquired taste. And many people may not have the time to dedicate to reading several of them right now.
Given that (and the unprecedented economic and market environment we’re living in right now), it’s time to create the starter’s guide to my risk signals.
Below, I’ll give a 30,000 foot view of each of the signals, how to interpret them and how to put into practice what the signal is telling us. I’ll also include a link to the original papers (in case you want to understand the background in more detail).
But before I do that, I want to address another question that comes up frequently.
Which signal should I follow?
The cop-out answer is it depends. It depends on your personal risk preferences, what your time horizon is and how active you’re willing to be in monitoring your portfolio.
Some folks follow one singular strategy. Others follow a mix of all four. Some implement the signals in their entire portfolio. Others use it in just a percentage of their portfolio. It ultimately depends on your comfort level.
But it’s important to recognize that not all of the signals are equal. They measure different factors over different time periods. The short-term signals, for example, are based on indicators that shift more frequently and should be used by investors willing to trade more frequently based on short-term sentiment changes. If you’re a long-term buy-and-hold investor who wants to make gentle or gradual changes to your portfolio over time, this may not be the signal for you.
Conversely, the long-term S&P 500 200-day moving average signal is a bigger ship that takes longer to turn. If you’re a trader that sees a sector rise in value three days in a row and wants to capture that momentum, this signal probably won’t work for you.
In short, which strategy to follow is based on your personal objective and trading style. Hopefully, this summary will give you a better idea of which signal is more appropriate for you and how it will work.
With that having been said, let’s dive in!
SHORT-TERM SIGNAL: UTILITIES/S&P 500 RATIO
This strategy is predicated on the broad notion that investors tend to seek out risk when economic and market conditions are good and take risk off the table when conditions are poor. Within the equity markets, the utilities sector is generally considered the most defensive given that the demand for electricity, water and other necessities should remain constant despite economic conditions. Since stock prices tend to be the ultimate leading indicator, seeing the utilities sector outperform the broader market could be an indication that market watchers see economic conditions deteriorating.
Outperformance in the utilities sector could be a function of many things. Investors, worried about increasing recession risk, could be rotating into lower beta sectors in an effort to add some downside protection to their portfolio. In especially low yield environments, like the one we’re currently in, investors may turn to utilities to generate higher yields. Both situations indicate poor economic prospects that could, in theory, drive investors more towards risk-off assets.
Since a portfolio following this signal is fully invested in equities at all times, it doesn’t necessarily aim to profit during down markets. The likely outcome would be falling less than the broader market.
Since utility sector performance relative to the S&P 500 is usually based on short-term market sentiment, this strategy is more appropriate for short-term traders with a higher tolerance for risk that wish to maintain full exposure to equities at all times. It tends to flip between risk-on and risk-off more frequently and is often the first of the four signals to change.
How To Implement This Strategy
As is the case with all four signals, implementation of this signal in your portfolio involves investing in one asset or the other. In this case, I use the Utilities Select Sector SPDR ETF (XLU) and the SPDR S&P 500 ETF (SPY) as my proxies.
As the utilities sector begins to show signs of outperformance, the portfolio moves 100% into XLU in order to take advantage of the market’s defensive shift. Conversely, as the broader market begins to outperform, investors would move back into SPY.
This strategy could work both for shorter-term momentum traders looking to anticipate changes in market risk tolerance or longer-term investors who want to remain fully invested in stocks at all time, but shift their portfolio allocations periodically in response to current conditions.
SHORT-TERM SIGNAL: LONG DURATION/INTERMEDIATE DURATION TREASURIES RATIO
This signal is in the same spirit as the Utilities/S&P 500 signal, but instead uses the Treasury market as its benchmark.
We know that, in general, stocks and bonds tend to move in opposite directions. Of course, that hasn’t happened as much in 2020, but, historically, that’s usually the relationship. As economic conditions deteriorate or sentiment turns negative, investors often move away from stocks and towards the relative safety of Treasuries. Measuring long-term bonds against intermediate-term bonds gives us a sense of overall buying in Treasuries and removes equity price activity from the equation. Even in environments where stocks are rising, this signal can move risk-off if buying in Treasuries remains strong.
It’s important to examine the Treasury market independent of the stock market because it tends to more accurately reflect economic conditions and expectations. The stock market is more vulnerable to exuberant trading activity (see Tesla), whereas the Treasury market tends to remain more grounded in reality. I often mention that the bond market tends to be right about the state of the economy more often than the stock market. Therefore, this is an important ratio to watch.
In short, when long duration bonds outperform, it indicates investors are becoming more cautious and moving into safe havens. This would be the risk-off indicator within this signal. Since this signal flips back and forth between stocks and bonds, two asset classes that, again, tend to move in opposite directions, investors give themselves a better chance of generating gains in both up and down markets.
How To Implement This Strategy
While this signal looks strictly at Treasury prices, the practical application of the strategy involves investing in either the S&P 500 (SPY) or the iShares 20+ Year Treasury Bond ETF (TLT). During a risk-off signal, Treasuries are the play, while risk-on indicates investors should move into the S&P 500. I use long-term Treasuries because it provides an opportunity for your portfolio to produce positive returns even when stocks are falling.
The question often arises about whether you can make substitutions for certain assets. In some cases, it would be OK, but generally not when it veers too far away from the strategy’s original intent. For example, someone once asked about replacing TLT with Treasury bills or cash. Moving into a non-performing asset like cash takes away the “profit on both sides” aspect of the strategy. During a risk-off period, you’d be losing potential upside. If you wanted to substitute TLT with, say, the iShares 10-20 Year Treasury Bond ETF (TLH), that’s probably fine since they respond similarly even though TLH is more conservative.
This signal would work well for someone who wants to more closely follow what the economy is telling us as opposed to the more emotionally vulnerable stock market.
INTERMEDIATE-TERM SIGNAL: LUMBER/GOLD RATIO
This is another signal which compares the price behavior of a traditionally cyclical asset against the price behavior of a traditionally defensive asset. The theory behind it is that when the economy is strong, material and commodity prices tend to rise due to the increased demand resulting from higher industrial production and manufacturing. In this case, I’m looking at lumber because there’s a need for building materials in almost every corner of the economy. Lumber is most prevalent in the housing market, where a stronger economy generally means more home construction, home improvement projects, etc. That, in turn, results in higher lumber prices.
On the flip side, when the economy turns sour and investors flee for safer shores, gold tends to rise in demand. I’ve noted before that gold is, in reality, an uncorrelated asset as opposed to a negatively correlated asset, so it’s not the pure defensive hedge one might think it is. Still, it tends to often behave in that way, so I use it as a defensive proxy.
In a stronger economy, lumber prices should rise due to increasing manufacturing and housing demand. Therefore, this signal would move risk-on when lumber outperforms. On the other hand, when sentiment turns south, investors seek safe haven assets. This indicator flips to risk-off when gold outperforms, indicating investors should shift defensively.
The current market has been an interesting environment for this ratio because both lumber and gold prices have been rising quickly. That tends not to happen, but this is a one-of-a-kind economy. Rising lumber prices are reflecting the red hot housing market, which is, in part, being fueled by record low interest rates. This is happening despite weakness in almost every other corner of the economy. Gold is rising because all of the government stimulus is finally devaluing the dollar. With real yields falling further into negative territory, the 0% yield of gold looks comparatively attractive! That’s been making it a little more difficult than normal to interpret this signal.
How To Implement This Strategy
This is the one strategy where I provide a number of risk-on/risk-off pairs depending on your personal preferences. That could involve an all-equity pair, such as the S&P 500 and low volatility stocks. For more aggressive investors, it could be high beta stocks and the S&P 500. For those looking to move back and forth between stocks and bonds, it could be growth stocks and long-term Treasuries.
There are a lot of different options available. Some, of course, have worked better historically than others, but they all involve the same general principle. When lumber prices rise, it indicates a healthy economy where investors should be adding risk. When gold outperforms, investors should consider becoming more conservative.
LONG-TERM SIGNAL: S&P 500 200-DAY MOVING AVERAGE
One of the most popular indicators among chart watchers is the 200-day moving average. In general, the 200DMA lets us know if a stock is trending up or down. In theory, investors would buy a stock when it’s above its 200DMA because it would be considered to be in an uptrend. On the flip side, investors would sell a stock when it crosses below its 200DMA because it would indicate that the uptrend has ended.
This signal is a straightforward play on that strategy, but we’re not selling when the S&P 500 falls below its 200DMA. Instead of buying when it crosses above the line and selling when it falls below, we’ll own the S&P 500 at all times, but double the leverage of the index when it’s trading above the 200DMA. It’s a decidedly more aggressive strategy than the others already presented. Instead of the typical low risk/high risk pair, think of it as a high risk/higher risk option.
As I noted in the paper itself, volatility is the enemy of leverage. High volatility is usually associated with down markets and that can kill a portfolio’s returns, especially since volatility can spike with little notice. We can’t solve that problem necessarily, but we can remove leverage from a portfolio when indicators suggest things could turn. Adding leverage during calm markets, while removing it when sentiment starts turning negative gives investors a better chance to come out ahead on a net basis overall.
This is a signal that could work well when used in conjunction with one of the short-term signals. As I mentioned before, since it uses 200 trading days of history, it tends to be slow to turn and can miss responding quickly in sharply changing market conditions. We saw that happen during the Q4 2018 mini-bear market, when stocks fell 20% in less than 3 months, and again this year, when stocks fell sharply in February/March and rebounded nearly as quickly. The slow-moving 200DMA wasn’t able to keep up with the rapidly changing market.
Pairing this with a short-term signal could help give an early indication that conditions are changing before the 200DMA signal flips one way or the other.
How To Implement This Strategy
When the S&P 500 is below its 200DMA, the signal is risk-off and investors remain in the S&P 500 (SPY). When it moves back above, the uptrend is essentially confirmed and investors move into a leveraged S&P 500 position, represented by the ProShares Ultra S&P 500 ETF (SSO).
Again, this is designed to be more of a strategy that allows investors to capture the long-term performance of equities, while occasionally enhancing those returns during periods of relative market calm.
Conclusion
While each of the signals uses different indicators to assess market conditions, the general investment strategy behind all of them is the same. When the signal suggests risk-off conditions, invest in the more conservative asset with the chosen pair. When it’s risk-on, invest in the more aggressive option. There’s a momentum strategy involved in the signals that essentially adds risk exposure when prices are rising and tries to avoid it when prices are falling.
The use of four signals instead of one using a wide variety of indicators helps provide a more all-encompassing view of the markets and allows the opportunity to zero in on a strategy that meets your personal objective. They’re all backed by proven track records of success, which you can see both in the papers themselves or in the graphs on the weekly risk signals report. They allow for some flexibility, but not so much that you fundamentally alter the risk/reward profile.
As always, message me directly and I can help guide you and identify the signal or signals that may be most appropriate for you.
The Lead-Lag Report is provided by Lead-Lag Publishing, LLC. All opinions and views mentioned in this report constitute our judgments as of the date of writing and are subject to change at any time. Information within this material is not intended to be used as a primary basis for investment decisions and should also not be construed as advice meeting the particular investment needs of any individual investor. Trading signals produced by the Lead-Lag Report are independent of other services provided by Lead-Lag Publishing, LLC or its affiliates, and positioning of accounts under their management may differ. Please remember that investing involves risk, including loss of principal, and past performance may not be indicative of future results. Lead-Lag Publishing, LLC, its members, officers, directors and employees expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.
Micheal, in Leverage for the Long Run I believe the strategy was Leveraged S&P 500 ETF when the S&P 500 is above its 200 day Moving Average and sell and rotate into Treasuries when the S&P 500 is below its 200 day Moving Average. Why didn't you mention Treasuries when talking about the 200 day MA signal above? Thanks for the education.