Where are equity markets heading? A tactical BUY opportunity for Global Equities?

The evidence from mean-reversion modelling

From:

John P. Cuthbert BA, MA, MSc Independent Financial Economist August 26, 2011 john@fundconsulting.f9.co.uk

Overview This our latest update following our last in March 2011. It is based on data for the week ending 19/8/11. As with earlier work, this analysis seeks to demonstrate that a great deal of asset pricing behaviour can be meaningfully described as mean reverting. These mean-reversion phenomena exhibit: Distinctive statistical characteristics (such as auto-correlated trends, and/or clear probabilistic boundaries at the extreme); They are usually associated with real-world business cycle events; And, most importantly, using this analysis it is possible to identify profitable market timing opportunities and also to think about the statistical signals in conventional strategic terms. Our approach essentially follows the idea that forecastable events can be conceived of as probability bounded sets of risk and return correlations. In practice, because asset pricing is multi-dimensional, no one screen is reliable. Instead, we use a combination of models (2 Mean Reversion, 2 Moving Average, 1 Information Ratio, 2 Expected Return, and a Risk model) to stress-test the reports of different indicators, and to build an asset pricing picture that captures as much information as possible. This approach has a telling forecast record. In our August 2010 update, for example, we pointed out that equity markets had entered a new mean-reversion phase, and in November 2010 we reiterated that even though this mean-reversion phase exhibits strong return outperformance, statistically it is not the sort of pricing phase that can be associated with a bull market. Rather it marks the end of the Recovery phase in the business cycle when markets wrestle with uncertainty about the sustainability of economic growth. In a normal cycle this phase ends with a sharp equity sell-off, and then transitions to a more stable pattern where trending and rotational behaviour rather than mean-reversion are more common. Indeed in our last update we were looking for this negative mean-reversion phase (in which equities are under pressure) to end in H1 2011 and for markets to transition to a different type of pricing phase, albeit one greatly dependent on economic newsflow.

A brief recap of recent signals In a normal business cycle, the transition from the Recovery phase to the Mid-Cycle phase has a very definite statistical imprimatur in mean-reversion terms, though it can appear very noisy using standard technical analysis techniques. This time round, even the meanreversion measures were very noisy. In our last note, for example, we reported that a buying opportunity lurked ahead following a sharp sell-off. This juncture appeared to arrive (earlier than expected) in mid-March, but we decided not to signal that as a BUY opportunity because our other screens (which we use to confirm the mean reversion signals) were not consistent with this being a market low. Equity markets did however bounce at this juncture but, after a 6% relative to Sovereigns move, the rally petered out in early April (see chart below)1. FTSE World vs Global Govt Bonds mean reversion drift
30

20

10 relative return %

0
To 20/12/2002 To 31/01/2003 To 14/03/2003 To 25/04/2003 To 06/06/2003 To 18/07/2003 To 29/08/2003 To 10/10/2003 To 21/11/2003 To 02/01/2004 To 13/02/2004 To 26/03/2004 To 07/05/2004 To 18/06/2004 To 30/07/2004 To 10/09/2004 To 22/10/2004 To 03/12/2004 To 14/01/2005 To 25/02/2005 To 08/04/2005 To 20/05/2005 To 01/07/2005 To 12/08/2005 To 23/09/2005 To 04/11/2005 To 16/12/2005 To 27/01/2006 To 10/03/2006 To 21/04/2006 To 02/06/2006 To 14/07/2006 To 25/08/2006 To 06/10/2006 To 17/11/2006 To 29/12/2006 To 09/02/2007 To 23/03/2007 To 04/05/2007 To 15/06/2007 To 27/07/2007 To 07/09/2007 To 19/10/2007 To 30/11/2007 To 11/01/2008 To 22/02/2008 To 04/04/2008 To 16/05/2008 To 27/06/2008 To 08/08/2008 To 19/09/2008 To 31/10/2008 To 12/12/2008 To 23/01/2009 To 06/03/2009 To 17/04/2009 To 29/05/2009 To 10/07/2009 To 21/08/2009 To 02/10/2009 To 13/11/2009 To 25/12/2009 To 05/02/2010 To 19/03/2010 To 30/04/2010 To 11/06/2010 To 23/07/2010 To 3/9/2010 To 15/10/2010 To 26/11/2010 To 7/1/2011 To 18/2/2011 To 1/4/2011 To 13/05/2011 To 24/06/2011

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From this mean reversion level equities attempt to rally twice in 2011

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Strangely, our leading Equity/Sovereign Bond model repeated this behaviour in mid-June. Once again Global Equities bounced around the same mean reversion level as in mid-March, and once again the pro-equity bounce petered out after a few weeks (and a sharp 5% relative return move). Looking at the statistical behaviour of markets reveals a great deal about the strength of the underlying trend, but most importantly of all, behaviour of this type is crucial for generating the signals from our forward looking models.....

The chart captures the drift term in a standard mean-reversion equation. The drift term is one of two properties in our Ornstein-Uhlenbeck approach (its a common mistake to think of mean reversion as just one variable), and might be thought of as expressing the trend. In the chart the statistical signal is converted into a relative return.

For example, one way of estimating the forward performance implications of the statistical behaviour captured in the mean-reversion models is to use an Information Ratio (IR) model. The IR is a special type of moving average (so it captures trend behaviour), and although we also use moving average techniques, the IR is particularly useful because it is expressed in standard deviations, and so as magnitudes approach the limit of what is normal variation the probability of a turning point ahead becomes much more pronounced. Through the early part of Q2 2011 the main Global Equity/Sovereign Bond IR model was signalling an IR bottom ahead consistent with the ending of the current mean reversion phase (or Recovery phase of the business cycle), and events seemed to be unfolding in a fashion not dissimilar to the transition to the mid-Cycle phase in the last business cycle (20042005). (In the chart below, the blue trend line is the historic IR trend, and the red trend line is a week-by-week 12 week forward forecast.)

FTSE World vs. Global Govt Bonds Information Ratio trend & trend forecast
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standard deviations

0
To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 IR (52W) IR (36W) projected

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In mid-June The IR 'meanreversion' model is forecasting a phase low in September 2011, and at a roughly similar level to the low at the same juncture in the last business cycle.

But these IR or moving average models are dynamic models, and they change or evolve as the underlying mean-reversion models capture important statistical events in the underlying price movements of the Global Equity and Global Sovereign bond indices2. The two failed equity market bounces shown in the earlier mean reversion screen are a case in point. The IR model can tell us something about the forward implications of such pricing behaviour, and the main effect of these events on the IR forecast was that by mid-July the IR forecast signal had been transformed into something much more portentous (see overleaf).
2

They actually capture a complex mix of stochastic and exponential phenomena.

standard deviations
0 1 2 3 4

-3 IR (52W)

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The rest we know.... A Portent: FTSE World vs. Global Govt Bonds Information Ratio trend forecast changes sharply
IR (36W) projected

By late-July the main Global Equity/Sovereign Bond IR forecast model signalled (as can be seen by comparing the signal with the previous chart) that the 3-month forward IR would abruptly fall more than 1 standard deviation into negative IR territory implying substantial losses in equities ahead......

IR predictive signal slumps in late July!

To 20/12/2002 To 21/02/2003 To 25/04/2003 To 27/06/2003 To 29/08/2003 To 31/10/2003 To 02/01/2004 To 05/03/2004 To 07/05/2004 To 09/07/2004 To 10/09/2004 To 12/11/2004 To 14/01/2005 To 18/03/2005 To 20/05/2005 To 22/07/2005 To 23/09/2005 To 25/11/2005 To 27/01/2006 To 31/03/2006 To 02/06/2006 To 04/08/2006 To 06/10/2006 To 08/12/2006 To 09/02/2007 To 13/04/2007 To 15/06/2007 To 17/08/2007 To 19/10/2007 To 21/12/2007 To 22/02/2008 To 25/04/2008 To 27/06/2008 To 29/08/2008 To 31/10/2008 To 02/01/2009 To 06/03/2009 To 08/05/2009 To 10/07/2009 To 11/09/2009 To 13/11/2009 To 15/1/2010 To 19/03/2010 To 21/05/2010 To 23/07/2010 To 24/9/2010 To 26/11/2010 To 28/1/2011 To 1/4/2011 To 3/06/2011 To 5/08/2011 To 7/10/2011

Current Mean Reversion signals: Is this a BUY for Global Equities? We have, of course, had a sharp correction In Global Equities but markets have not reached the levels implied in the IR forecast model. So the issue is: Do equity markets have further downside? One way to think about an answer to this question is to look at how Oversold Equity markets are relative to their history. Thats captured in the chart below. The current analysis indicates that Global Equities are not only more deeply Oversold than after last years sell-off, in standard mean reversion terms (namely the normalised probabilistic relationship of recent returns with an appropriate moving average), Global Equities are more Oversold than at any point in the last 20 years or so.
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Global Equities vs. Global Govt. Bonds mean reversion screen (1993-2011)
1.5

0.5

standard deviations

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To 28/05/1993 To 15/10/1993 To 04/03/1994 To 22/07/1994 To 09/12/1994 To 28/04/1995 To 15/09/1995 To 09/02/1996 To 28/06/1996 To 15/11/1996 To 04/04/1997 To 22/08/1997 To 09/01/1998 To 29/05/1998 To 16/10/1998 To 05/03/1999 To 23/07/1999 To 10/12/1999 To 28/04/2000 To 15/09/2000 To 02/02/2001 To 22/06/2001 To 09/11/2001 To 29/03/2002 To 16/08/2002 To 03/01/2003 To 23/05/2003 To 10/10/2003 To 27/02/2004 To 16/07/2004 To 03/12/2004 To 22/04/2005 To 09/09/2005 To 27/01/2006 To 16/06/2006 To 03/11/2006 To 23/03/2007 To 10/08/2007 To 28/12/2007 To 16/05/2008 To 03/10/2008 To 20/02/2009 To 10/07/2009 To 27/11/2009 To 16/04/2010 To 3/9/2010 To 21/1/2011 To 10/06/2011

-0.5

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-1.5

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LTCM Post TMT Bubble Crash

Post Lehman Bros Credit Crunch

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jTAM Normlized Active Rtn 52W

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Equities are more Oversold (in relative probability terms) than any point in last 20 or so years!

Does this make sense? Even if the US and European economies are heading for recession, the mean reversion map above suggests that recent market events have priced something much more dramatic. In essence, equities have already priced a Crash type event, and even though the IR model points to more downside, the mean reversion screen above is telling us that this is not likely. Indeed, as can be seen from the chart, in the two most comparable episodes of the last 10 years (LTCM and 9/11) equities subsequently experienced a very sharp technical bounce. However, as was the case post the Lehman Bros bankruptcy, such a bounce could prove to be just a tactical event. We will only know the longer-term path for equities as we observe how any bounce evolves over the next few weeks. Importantly, equities have to breach the failed mean reversion limits of March/April and June in order for the IR measure to signal better sustained prospects for equities ahead. 6

Looking for Global Equities BUY signal confirmation The preceding analysis indicates that there is a high probability of a sharp technical bounce in Global Equities. This is obviously a big call, and requires high confidence. From a forecast point of view, one way of reinforcing our forecast (rather than just relying on mean reversion probability) is to build confidence by attempting to reconcile the signal for Global Equities with the presence of two further elements. A bottoming and turning in the forward IR signal for Global Equities vs. Govt Bonds (which would gesture that markets have already reached an important low); A confirmation that a similar signal is also present on a wide range of other asset classes. In this first regard, the current IR signal is hinting at a turning point, and were we to add in this weeks current market bounce, then the up-turn would look more prominent in the chart below.
Global Equities vs. Global Govt Bonds current Information Ratio trend and forecast IR trend

standard deviations

0
To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 To 14/10/2011

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Current IR level
-2 IR (52W) -3 IR (36W) projected

Forecast IR is hinting at a bottom, suggesting a turning point has been reached.

More broadly, that is in regard to our second source of confirmation, a number of key markets (FTSE Brazil, China, India, FTSE Europe, Topix) and asset classes (UK Small vs. Large, Europe Small vs. Large, and Russell 2000 vs. S&P 100) are already exhibiting turning points in their IR signals. Indeed, as the chart example overleaf testifies, a number of asset class IR forecasts are now at Lehman Bros Credit Crunch crash levels (Euro vs. SWF, S&P Mid-Cap vs. S&P Large-Cap, Russell 2000 vs. S&P Large Cap, and MSCI Brazil)! If there is no recession in the US/Europe, and certainly no Crash event, then these models indicate that markets are simply excessively pessimistic! 7

standard deviations 0 1 2 -2.5 0.5 1.5 2.5 -2 -1 -1.5 -0.5 3 4 5

standard deviations 3

In this regard, the IR signal for Chinese Equities which has long been the leading indicator of the leading indicators, also signals some hope on a longer term view.

Such analysis suggests markets are at a significant juncture. The fulfilment of such a sharp downside projection in the IR signal for the Russell 2000 (as with equities generally) will require a Credit Crunch type event to drive markets to these levels. In contrast, because the IR forecast is exponentially weighted, if equities were to bounce for several weeks, then, the sell-off signal would contract sharply and would confirm that recent market behaviour has just been too pessimistic! Thats what the mean reversion models are suggesting will happen.

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IR (52W) IR (36W) projected

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Russell 2000 vs. Global Govt Bonds IR trend and forecast trend

Shanghai Composite Information Ratio trend and forecast IR trend

IR (52W)

IR (36W) projected

Russell 2000 IR signal bottoming

To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 To 14/10/2011

To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 To 14/10/2011

Chinese equities forecast to bottom at a less distressed level

downside potential

According to the chart overleaf, Chinese A Share markets are experiencing a more typical cycle-based mean reversionary pricing pattern; the forecast IR low is both lower, more imminent, and the incipient signal of an expected bounce is also visibly stronger (consistent with an imminent ending of monetary easing, an inflation peak, or stronger economic data). A forecast low in Chinese equities (presaged on a change in Chinas economic tempo), prefigures a better period ahead for Global Equities (namely something beyond a tactical event). That might appear to be something of a long-shot given the weight of current economic and credit problems, but the same prospect is also visibly present in the IR model for Indian equities. MSCI India (vs. Global Govt Bonds) Information Ratio trend & Forecast trend

standard deviations

current level

0
To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 To 14/10/2011

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-2 IR (52W) -3 IR (36W) projected

Indian equities forecast to bounce at same juncture as Chinese equities

Importantly, in contrast to the Chinese equity A Share market, the above IR trend chart for Indian equities pre-figures the end of a major mean-reversionary pattern (it stretches back to mid 2010 coincident with the peak in the cycle and subsequent policy tightening). So India is behaving a little differently from China, but crucially, both markets are indicating that a turn in the IR performance trend has been reached! This evidence helps to build confidence in the tactical BUY signal on Global Equities (because cycle driven mean revisionary phenomena attend to be more predictable and so are less likely to be associated with forecast error), but given that both markets are driven by local drivers (rather than credit events), a contiguous bounce would more likely have sustainable legs. That would point to a better and more sustained improvement in the outlook for Global Equities beyond that suggested by our current tactical call. (A similar signal is in place for the MSCI Brazil, but the forecast turning point is much lower and later implying a less favourable tactical outlook for Brazilian equities, but a prefigured end to the Brazilian equity bear market relative to Sovereigns nevertheless lies ahead.)

Looking for further confirmation.... Another useful measure of signal confirmation can be divined in the behaviour of Consumer Staples relative to Cyclicals (in this case the MSCI Industrials index).
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MSCI Consumer Staples vs MSCI Industrials mean reversion drift (2002-11)

Global Consumer Staples approaching Lehman Bros Overbought levels OVERBOUGHT

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0 relative return %

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superdetrended active cumul

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As the chart above makes plain (its a mean reversion chart expressed in relative return terms), Global Consumer Staples have only been as stretched as this relative to Global Industrials once in the last 10 years or so! That implies a better performance outlook for Global Industrials, indeed the mean reversion trend model implies a 25% total return bounce from here if Industrials reach the top of their mean reversion range. Another plausible area of confirmation for the tactical signal on Global equities is the behaviour of a defensive haven, namely Gold. Its difficult to get a complete read across for Gold relative to other asset classes (in part because futures markets behave differently to spot prices), but even with this caveat in mind, looking at how Gold has been trading is a reminder that A further sell-off in equities is not the only potential risk in the current environment. Gold is now trading at the limits of its normal mean-reversion range (i.e. the distance from an appropriate moving average), and as the mean reversion chart overleaf makes clear, a seachange in risk conditions and a full mean-reversion correction in Gold would imply a 21% selloff)!

To 19/05/2000 To 08/09/2000 To 29/12/2000 To 20/04/2001 To 10/08/2001 To 30/11/2001 To 22/03/2002 To 12/07/2002 To 01/11/2002 To 21/02/2003 To 13/06/2003 To 03/10/2003 To 23/01/2004 To 14/05/2004 To 03/09/2004 To 24/12/2004 To 15/04/2005 To 05/08/2005 To 25/11/2005 To 17/03/2006 To 07/07/2006 To 27/10/2006 To 16/02/2007 To 08/06/2007 To 28/09/2007 To 18/01/2008 To 09/05/2008 To 29/08/2008 To 19/12/2008 To 10/04/2009 To 31/07/2010 To 20/11/2009 To 12/03/2010 To 02/07/2010 To 22/10/2010 To 11/2/2011 To 3/06/2011 OVERSOLD

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total return % 10 15 0 5

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But perhaps the most important confirmatory message from the mean reversion models is that Sovereigns have only been this Overbought four times in the last 20 or so years (see chart below). Indeed in the three episodes most similar to recent events ringed in the chart below (Sep 98, Sep 01, Jul 02), in all three cases, Sovereigns then reverted sharply to the bottom of their mean reversion ranges.

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OVERBOUGHT

OVERSOLD

Global Govt Bonds vs. Global Equities mean reversion drift (1993-2011)

superdetrended active cumul superdetrended active cumul

Similar mean reversion tops to current position

DJ UBS Gold ETF: mean reversion drift

To 28/05/1993 To 12/11/1993 To 29/04/1994 To 14/10/1994 To 31/03/1995 To 15/09/1995 To 08/03/1996 To 23/08/1996 To 07/02/1997 To 25/07/1997 To 09/01/1998 To 26/06/1998 To 11/12/1998 To 28/05/1999 To 12/11/1999 To 28/04/2000 To 13/10/2000 To 30/03/2001 To 14/09/2001 To 01/03/2002 To 16/08/2002 To 31/01/2003 To 18/07/2003 To 02/01/2004 To 18/06/2004 To 03/12/2004 To 20/05/2005 To 04/11/2005 To 21/04/2006 To 06/10/2006 To 23/03/2007 To 07/09/2007 To 22/02/2008 To 08/08/2008 To 23/01/2009 To 10/07/2009 To 25/12/2009 To 11/06/2010 To 26/11/2010 To 13/05/2011
To 20/12/2002 To 21/02/2003 To 25/04/2003 To 27/06/2003 To 29/08/2003 To 31/10/2003 To 02/01/2004 To 05/03/2004 To 07/05/2004 To 09/07/2004 To 10/09/2004 To 12/11/2004 To 14/01/2005 To 18/03/2005 To 20/05/2005 To 22/07/2005 To 23/09/2005 To 25/11/2005 To 27/01/2006 To 31/03/2006 To 02/06/2006 To 04/08/2006 To 06/10/2006 To 08/12/2006 To 09/02/2007 To 13/04/2007 To 15/06/2007 To 17/08/2007 To 19/10/2007 To 21/12/2007 To 22/02/2008 To 25/04/2008 To 27/06/2008 To 29/08/2008 To 31/10/2008 To 02/01/2009 To 06/03/2009 To 08/05/2009 To 10/07/2009 To 11/09/2009 To 13/11/2009 To 15/1/2010 To 19/03/2010 To 21/05/2010 To 23/07/2010 To 24/9/2010 To 26/11/2010 To 28/1/2011 To 1/4/2011 To 3/06/2011 To 5/08/2011

Gold is trading at the limits of its normal mean reversion range . A correction to the bottom of its range would imply a 21% sell-off!

current position

11

Caveats... Taken together, this looks like strong confirmation for a tactical BUY signal on Global Equities. But a high probability of a technical or tactical bounce in equities is not the same as saying that a new mean reversion phase has been reached for equities (implying sustained equity out-performance). Moreover, there are two key caveats that suggest that any BUY recommendation should be limited to a tactical perspective. For a more longer-term positive view on Global Equities to prevail will require more evidential support. The two caveats are: The risk models forecast further risk upside; The Global Govt Bond model points to a further bounce in Sovereigns in the months ahead.

Caveat 1: Elevated risk As the chart below indicates both the risk trend (blue line) and the forecast risk trend-line (red) have turned up sharply. As risk expands the probability of a sharp sell-off rises. Equally, a continued rise in volatility implies a deepening bear market with further substantial sell-offs likely! During a normal business cycle risk should not only be trending down (or flat), it should also be at a lower level. That implies that a decline in the forecast levels of volatility is a necessary condition for a return to a more normal asset pricing environment or more normal conditions for the mid-cycle phase of the business cycle! So as things stand, the risk model is a major worry, but as with the mid-2010 sell-off, where risk rose sharply then fell away, we conjecture that a characteristic of this cycle will be that risk will tend to transition (consistent with a normal cycle) but then be punctuated by violent episodes of spiking risk (consistent with the pricing of something out of the normal).
50

Global Equities vs. Global Govt Bonds risk trend and risk forecast trend
45 40 35 30

variance

25 20 15 10 5 0

historic variance (rolling 52W) forecast variance (rolling 36W)

Risk turns up and is forecast to keep rising

To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 5/08/2011 To 14/10/2011

12

Caveat 2: A message from Global Government Debt As we have observed, Government Debt is massively Overbought on our mean reversion models, but in balance-sheet recessions of the type being experienced in the US and Europe, Sovereigns can remain Overbought for sustained periods of time as the yields of even longerdated bonds trend to zero. Indeed, even though the recent equity sell-off bears a closer resemblance to previous crash episodes rather than the post-Lehman Bros bankruptcy, the 2008 episode reminds us that the transition from Overbought (as Bonds were in October 2008) to a sustained under-performance trend in Government Bonds (which they became by mid-2009) can be a rocky one. In this regard, the current IR signal on Global Govt Bonds Asset Allocation model (namely in comparison to itself) deserves a little attention. Global Govt Bonds Information Ratio trend and IR forecast trend
Sovereign Bond IR trend is in a strong upward phase, but the forecast signal suggests a correction followed by a bounce

2 standard deviations

0
To 20/12/2002 To 28/02/2003 To 09/05/2003 To 18/07/2003 To 26/09/2003 To 05/12/2003 To 13/02/2004 To 23/04/2004 To 02/07/2004 To 10/09/2004 To 19/11/2004 To 28/01/2005 To 08/04/2005 To 17/06/2005 To 26/08/2005 To 04/11/2005 To 13/01/2006 To 24/03/2006 To 02/06/2006 To 11/08/2006 To 20/10/2006 To 29/12/2006 To 09/03/2007 To 18/05/2007 To 27/07/2007 To 05/10/2007 To 14/12/2007 To 22/02/2008 To 02/05/2008 To 11/07/2008 To 19/09/2008 To 28/11/2008 To 06/02/2009 To 17/04/2009 To 26/06/2009 To 04/09/2009 To 13/11/2009 To 22/01/2010 To 02/04/2010 To 11/06/2010 To 20/08/2010 To 29/10/2010 To 7/1/2011 To 18/3/2011 To 27/05/2011 To 12/08/2011 To 21/10/2011 IR (52W) IR (36W) projected

-1

-2

Such a signal (because it is exponentially weighted) is very dependent on incoming data, but as things stand it is a reminder that there are many potential perils for Global Equities to overcome ahead before it is wise to call an equity bounce in the West anything more than a bull bounce in a bear market.

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Conclusion: The bottom line The key message from our latest mean-reversion modelling update is that Global Equities have reached a key Oversold level that implies that tactically conditions have improved markedly. In the three similar episodes over the last 20 years when equities were as Oversold as this, there was a subsequent strong and sustained bounce in equity performance. On our mean reversion drift model (see chart page 6), a sustained bounce in Global equities to the top of its mean reversion range would imply a return of 21% relative to Global Sovereigns from here (as of 19/8/11). Its a big call to leave the safe haven of Global Sovereigns and Defensive stocks, so strong confirmation is required. The strongest confirmation for this tactical' message stems from the behaviour of other asset markets and asset classes. In particular, our forecast IR signals for UK Small vs. Large, Europe Small vs. Large, Russell 2000 vs. S&P 100, S&P Mid-Cap vs. S&P LargeCap, MSCI Industrials vs. MCSI Consumer Staples, and Euro vs. SWF all are exhibiting tactical BUY signals. In essence our IR models (which project more downside on the current trend, where our mean reversion models are saying that a crucial level has been reached) are suggesting that the recent equity sell-off was not a pure business-cycle phase driven mean reversion event, but a Crash type event! Of course, Crash events of this type have a high probability of taking some time before the Markets concerns are fully resolved, (which is just a way of saying that that there is a high chance of many sharp bounces and sell-offs ahead before any absolute statistical clarity can be obtained), but equally it indicates that it will take a substantial Credit Crunch type collapse to drive equity prices lower from here. A confirmation of a US recession will not be enough (it appears to be already priced). The corollary of this is that in the absence of a real Crash, then, equities have substantial upside, but we think that it will take positive news flow on Q3 US economic data, Fed intervention, an extension of the US payroll tax reductions into 2012, a reversal of ECB monetary policy and its successful intervention in capital markets to ensure that our 21% relative upside forecast for Global Equities can be achieved! Until such positive news flow is present the BUY signal on Global equities should be considered purely a tactical or short-term one. Indeed, our IR and Risk forecast models caution that risk conditions remain elevated and unless these risk conditions change - in the longer-term there remains a high probability of further sell-offs. From statistical point of view, a better longer-term outlook for equities will require not only that any bounce reaches something like the top of its mean reversion range (remember two attempts to do this in March/April and June failed), but also that any equity bounce conjures a forecast signal in our IR and Moving Average models that indicates a new mean reversion phase is about to begin. In this regard, perhaps the most interesting observation contained in this report is that in three key BRIC equity markets, two of which are in pronounced bear type phases consistent with unusual levels of policy tightening (China and India), not only has a cyclical market 14

bottom been reached on our IR forecast models, if these forecasts are confirmed by subsequent positive economic news-flow, then, it would register the beginning of a new positive phase in the BRIC economic cycle. Its much too soon to make that call with complete confidence, but bear in mind that it is highly unlikely that such a signal on our models would prove to a be false positive (remember the BRIC countries are not suffering the aftermath of a Credit Crunch, their problem is Overheating). The exact trajectory towards and beyond any turning point however is less certain (our furthest forecast horizon is only 12 weeks), though this will become clearer over the coming weeks, and it is perhaps a little redundant to add that the imputed importance of such an event should encourage a close watching brief.

John P. Cuthbert, BA, MA, MSc, August 26, 2011

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