Tactical Investment Strategy For The S&P 500 Index With Potential Market Beating Returns

Monetary Stress Index

Has this market obtained you stressed? Frightened about mortgages, debt, or the inventory market and whether or not you may retire on time?

Sadly I haven’t got a repair for that, however there is a fairly shut second, and it comes within the type of a composite index that may assist you to perceive the every day state of the inventory market and quantify what “monetary stress” really means for the worldwide monetary system.

The OFR Monetary Stress Index is supplied by the Workplace of Monetary Analysis and it’s constructed utilizing 33 monetary market variables. When the FSI index is constructive it signifies that stress ranges are above common and value being attentive to, and when it’s damaging stress ranges are much less worrisome. We go into additional element on that under.

What’s value noting is that these are fairly heavy weight measures, a lot of that are utilized by the Fed and funding banks to gauge danger. For these with expertise in monetary markets the FSI consists of:

• Credit score – Credit score spreads, each HR and IG Company
• Fairness valuation – Inventory valuations, the inventory index value ranges
• Funding – Financial institution lending requirements, credit score circumstances index
• Secure Belongings – Valuations for property like Yen, CHF, Gold which are thought-about protected shops
• Volatility – VIX Index, Transfer Index, implied and realised volatility

What we’re going to do on this article is take this current index and back-test it in opposition to the S&P 500 index to show it into a really priceless and actionable useful resource.

Overview of the Monetary Stress Index and S&P 500

Let’s take a look at the entire dataset from the highest:

The FSI has accomplished job of protecting the recessions over the previous 22 years and being aligned to forecasting them with a level of accuracy.

Moreover if we glance carefully, not like fairly a couple of indicators, it really accurately responds to the drawn out nature of the Dot Com bust and stays elevated from 2000 till early 2003.

Total the index seems to have correlation with the inventory market. However how good? We are able to do a deep dive into two main crises after which backtest the mannequin in opposition to the S&P 500.

Evaluation of Dot Com Bust (2000-2003)

The Dot Com bust started in late 2000 on the peak of the web increase. Many people know the story so we can’t really feel the necessity to enter an excessive amount of element about what began the bust and the components main as much as it.

The FSI registered 2.236 in February of 2000 and this represented elevated credit score spreads, volatility rising and minor funding points within the monetary system. The mannequin remained elevated straight by to the formal onset of recession in 2001, the place it peaked at 5.68 in April 2001 after which troughed however remained above 2.5 into 2002. The mannequin was elevated all through 2002 and peaked even greater at 7.28 in October of 2002. By the top of the Dot Com bust it hit a damaging worth in July of 2003.

For those who had offered in January 2000 – when FSI was above 0, and purchased once more originally of July 2003 – when FSI was under 0, you’d have averted the -31.75% drawdown. This is not the complete drawdown however represents a good proportion of it.

Evaluation of World Monetary Disaster (2008-2009)

It is a comparable image for the World Monetary Disaster that began in 2007 however actually picked up steam in 2008.

The FSI Index went above 0 in August of 2007 and remained barely above that stage into 2008, the place it steadily rose in direction of a primary peak in April 2008 at 11.39. The index remained at this elevated stage till it actually took off, when the monetary system was melting down over the winter of 2008 between October and December – hitting an ear splitting all time excessive of 26.42 in October.

The mannequin returned to zero by January 2010. For those who had offered in August 2007 after which purchased again in when it hit zero in January 2010, you’d have averted -23.24% of the drawdown.

There have been repeat occurences linked to the monetary disaster that appeared in April to December of 2010, and once more in 2011 through the Occupy Wallstreet protests and the European Debt Disaster. Nonetheless fairly than cowl these intimately we’ll refer you to the next chart:

This reveals, once more, the mannequin capturing the strikes pretty effectively on the 0 level.

Total Mannequin Accuracy – Adjusting the Mannequin

Clearly if you happen to can keep away from a significant drawdown in two bear markets then the mannequin will need to have some utility, proper? That in fact will depend on whether or not the opposite time durations when it provides false alerts (the mannequin reveals monetary stress however as an alternative of shares taking place, they go up) compensate for the worth that you simply save throughout real monetary crises.

It is essential once we backtest a system that we do not cherry decide knowledge or assess it merely off of the outputs from a graph. As a substitute we should set honest parameters and account for buying and selling prices, transactional lag (by at some point) and durations when the mannequin underperforms.

With the intention to pretty assess the mannequin we checked out blanket guidelines throughout the entire knowledge set after which we used Python to backtest the efficiency of the mannequin underneath these circumstances.

Primary System – Guidelines & Situations

The primary check was for the essential system articulated above.

• If the FSI is under 0, the system is a purchase and also you personal the S&P 500 index (SPY)
• If the FSI is above 0, the system is a promote and also you personal money by SPDR Bloomberg 1-3 Month T-Invoice index (BIL)

The outcomes of the primary check are:

The vanilla system buying and selling out of the field produces a decent return of 671% between the yr 2000 and March 2023 YTD. That is in comparison with a value return on the S&P 500 index of 396%.

To reveal that there isn’t any monetary chicannery happening right here we additionally individually seemed on the S&P 500 whole return together with dividends, and having a extra aggressive mounted earnings possibility. Our backtesting reveals that if you happen to use the S&P 500 whole return index and now have your cash invested in TLT or LQD, you get an analogous stage of ourperformance.

However we are able to do higher!

Recursively Optimised System – Guidelines & Situations

The second check was for an improved stage of the FCI index. For those who discover, it triggers barely early throughout each crises. What if we examined all the potential set off ranges and set upon probably the most optimum?

To take action we use a recursive Python mannequin that loops by the info and back-tests it repeatedly till we discover an optimum determine. Quite than present all the outcomes we’ll laser in on what got here as an output from this recursive evaluation.

• If the FSI is under X, the system is a purchase and also you personal the S&P 500 index
• If the FSI is above X, the system is a promote and also you personal money by SPDR Bloomberg 1-3 Month T-Invoice index

There’s a vital enchancment within the mannequin after it has examined numerous choices, together with:

Click on to enlarge

The optimum stage for the FSI is definitely 1.5 and this results in a extremely exceptional outperformance:

The system now has a extra granular view of danger, which is calibrated to when the extent of monetary stress within the system is sufficient to warrant shifting your cash out of the market and into money or money equivalents.

Additional testing concepts embrace weighting the underlying constituents and getting into the market in sooner than the present mannequin. For instance throughout Covid as soon as the VIX hit an astonishing shut of 65 in March of 2020, when the volatility index subsided one may have taken an earlier lengthy place.

The important thing although is to not make this mannequin too difficult and to as an alternative depend on one thing that has a good and constant backtest with out over-fitting the info.

Limitations & Additional Analysis

To cowl off a possible rebuttal to this evaluation. You might be considering: “This solely goes again to 2000 and there have been two main monetary crises throughout that interval. You are cherry choosing the info.”

In a future article I’ll lengthen this evaluation to cowl a precursor to the FSI index, which was known as the NFSI index. There are a number of indexes that date again to 1993 (NFSI) and the Nineteen Seventies (ANFCI) and so they additionally present priceless knowledge for timing the market primarily based on monetary circumstances. Nonetheless, given their variations, I’ve determined to deal with them individually and within the subsequent a part of the collection in order that our readers can construct on their data and perceive the extra primary system first.

One purpose we consider {that a} buying and selling system primarily based across the Monetary Stress Index shouldn’t be commonplace is that macroeconomic timing has fallen out of favour. Have you ever ever heard of Martin Zweig? He was an influential funding adviser recognized for his data-driven research and macroeconomic timing fashions who as soon as owned the costliest penthouse on Fifth Avenue. Through the increase years of the Nineteen Nineties and 2000s his fashions underperformed the market. As with all method to producing alpha the efficacy waxes and wanes.

Outcomes

Utilizing the Monetary Stress Index as a information for deciding when to be lengthy the markets seems to be an affordable buying and selling technique predicated on the truth that, with elevated monetary stress within the system, there may be additionally elevated chance of a sell-off. We now have used this technique final yr as a proxy for danger, which allowed us to regulate our asset allocation accordingly.

For the vanilla mannequin that sells danger property when the Monetary Stress Index (FSI) goes above zero, and buys when it’s under 0, the mannequin returns 671% between 2000 and 2023 YTD in opposition to a return of 396% for the S&P 500.

With recursive optimisation utilizing Python we discovered that the mannequin produced a formidable 982% in opposition to 396% for the index, which represents a virtually 2.5 fold return in opposition to the index.