Three years ago we released the first version of Alquant’s Macroeconomic Indicator. Today, Alquant introduces a new version of its Macroeconomic Indicator. At Alquant we usually try to avoid making changes to existing indicators. Therefore, updating an indicator is rare for us and should be driven by a strong belief and/or proof that the change is for the better. Given our philosophy and approach, we believe any significant change must be communicated.

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The update could come as a surprise, as the first version performed relatively well. However, the superiority of the new version triggered the change.

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Performance of the new Macroeconomic Indicator from 2008–01–16 to 2021–04–21

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Reminder: What characterizes a good macroeconomic indicator?

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A good macroeconomic indicator should allow investors to get a bird’s eye view of the real global economy so they can spot impending recessions in advance or identify market exaggerations before they burst to position their portfolios accordingly. However, given the lagged reporting of macroeconomic data, many macro indicators end up identifying recessions and bubbles after they have occurred or burst, making them essentially useless.

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After extensive research, we concluded that the inclusion of the following two aspects helps to further improve the predictive power of the Macroeconomic Indicator:

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1. Relevant and leading economic data with a short time lag
2. The second derivative of these time series instead of their level or rate of change

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Before showing some results, we will briefly present these two points.

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Short time lag

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The goal of using data with a short time lag is to accurately nowcast (or if possible even forecast) global GDP or more generally speaking the global economic activity. Accurate nowcasting offers an advantage over investors who wait for official data, at the cost of a much longer lag. The previous version of the indicator was mainly based on monthly data, which is already relatively timely considering that major economic data is usually updated quarterly. However, the new version goes further by including U.S. data published weekly or even daily, thus further reducing the lag.

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The second derivative

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It should not be surprising that the current state of the global economy is usually priced in and thus contains almost no predictive power about future equity market returns. Even the trend (or rate of change) of the global economy is closely watched by investors so that it is of little use in predicting future equity market returns. To construct a macroeconomic indicator with predictive power, we believe it is crucial to focus on the change in the rate of change (i.e. to watch the sign of the second derivative) to anticipate whether the trend will continue not.

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Backtest results on the MSCI ACWI

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The new Macroeconomic Indicator works exactly like the old version:

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1. Every day before noon, Alquant publishes the risk level of the Macroeconomic Indicator on its platform. As the indicator is based exclusively on end-of-day data, the current risk level for each day is calculated using data available up to the previous close (at 10 pm).
2. The higher the risk level indicated by the Macroeconomic Indicator, the lower the equity exposure should be. Therefore, in the simplest approach, a risk level of 75% is translated into an equity exposure of 25%.
   (exposure = 100% — current risk level)
3. The backtested performance assumes that transactions are executed at the market close. For example, even though the March 3, 2021 risk level was available on Alquant’s Prisma platform before noon on March 4, 2021, the backtest assumes that the transaction was not executed until the market close on March 4, 2021. This ensures that the displayed performance is reproducible without slippage.

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Backtested performance from 2008–01–16 to 2021–04–21

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Backtested performance from 2008–01–16 to 2021–04–21

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The backtested performance on the MSCI ACWI is quite impressive. Indeed, the Macroeconomic Indicator almost doubled the annualized return while reducing the annualized volatility from 17.34% to 10.76%. In addition, the maximum drawdown was reduced to less than -20% and the Sharpe Ratio was almost tripled compared to a 100% constant exposure to the MSCI ACWI.

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However, as expected and evident from the chart presented at the beginning of the article, the Macroeconomic Indicator was particularly effective in predicting the 2008 global financial crisis and the COVID-19 crisis.

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Backtest results omitting the global financial crisis and COVID-19 crisis

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It is therefore interesting to observe how it performs when these two crises are omitted, i.e. when performance is analyzed from March 2009 to January 2020:

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Backtested performance from 2009–03–01 to 2020–01–31

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Backtested performance from 2009–03–01 to 2020–01–31

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Although less impressive as it delivered lower absolute returns than a 100% constant exposure to the MSCI ACWI, the statistics show that the Macroeconomic Indicator was still able to outperform on a risk-adjusted basis (higher Sharpe Ratio) by reducing the annualized volatility as well as the maximum drawdown, thus delivering overall a positive alpha and information ratio.

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Disclaimer

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This content is advertising material. This content as well as all information displayed on Prisma or any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.