Business Cycle Econometrics

[claywilk]

Quote from 2cents:

boy this is tough... ok, still struggling to organize my thoughts, here's my best shot for now... lemme know what u think...

2. ok with copper as a leading indicator for metals (and links to growth & development, emerging mkts notably) but i'd include gold/silver as well since they obey different dynamics, 'irrational' ones to some extent, but that's another pulse & dimension of the 'mkt' to be taken into consideration methinks... real estate indicators shld be included too, huge mkt & knock-on effects, how about new home sales?

3. i'm an fx guy. if u mean strength as in high DXY level as your chart seems to indicate, short answer is, in my experience neither is true, even if you were talking about real interest rates... if u mean strength as in the CB/Fed has got inflation expectations under ctrl and the country's not also slipping into recession, then again, neither is true. as far as huge & steady capital flows are concerned, what matters i'd say, if a few words can ever capture that, is more the consensus outlook for real & nominal growth in the leading size economies (G8 + China & India), and the anticipated path & rationale (accomodation removal, inflation/deflation risk fighting, etc) for short term (<2yrs) IR differentials between US & EC debt mkts (Japan's debt mkt is sizeable but not a contender). fairly topdown and somewhat asymetrical but that's how i believe the big money is looking at it. as for the 'other' 95% of purely speculative FX daily transaction volumes, they increase vol & range and cause the short-term (<3mths) gyrations that we can all see, but it's unclear whether they do anymore than that...

4. not sure what u mean here, please elaborate

5. agree

6. u mean 10yr yields going down as (real?) gdp growth is decelerating? thing is, i am not aware of a correlation here but i have not explored either. on yield spreads and real gdp growth, perhaps, but even then... for instance http://www.boj.or.jp/en/type/ronbun/ron/wps/kako/data/iwp00e03.pdf go to p7 etc... i am not a believer...

7&8. interesting, please elaborate

9. yes i have pretty much everything on bloomberg thks

apologies for not contributing much at all here... i do have a few research notes that you may find of interest but we'd need to get down to more defined sets of potential relationships. fwiw, what i am looking at right now is more:
. IR levels at which commodities mkts are likely to react (e.g. Frankel http://www.google.com/search?hl=en&...,SUNA:en&q=frankel+interest+rates+commodities )
. intra-day correlations & ripples resulting from sharp moves on oil, spot gold (xauusd) and $ pairs (caused by geopolitical events, hurricane scares etc)

Hey 2cents, I made a few more notes.

2)I usually ignore the metal markets perhaps to my own dismay. They very likely should be included in any realistic set of intermarket analysis.

3)As far as your dollar analysis, my thoughts would be that you seem to be focused almost entirely on the speculative pressures on prices rather than the purely transactional pressures. Do you believe that the transactionals offset well enough that the speculatives fully determine the direction?

4) I see what you mean about not understanding! Ha, bet it was late. What I meant by that was that you usually do not see the dollar rise as a result of rising interest rates at any given point, but rise once interest rates had peaked. As in the dollar rose as bonds rose ( interest rates falling) when investment flowed into US notes and bonds. Which indicates to me that it is less about interest rate differentials.

6) That was very bad typing. I should have said that If the dollar (not bonds) are rallying as the economy slows, what other factors would contribute to this? Less consumer spending on imported items? ..... Along conventional thinking the dollar should rise as the economy strengthens, alot because of the interest rate picture. However, we know that this isn't always the case.

7) The magic of the markets operate in a yin/yang fashion. Example; As the economy grows there are pressures on resources which causes a price rise. The price rise will dampen the growth of the economy. Interest Rates get higher because of emand for money, as they get higher they dampen the demand for money. Going back to Treasuries/Dollar as an example There are times when the dollar is rising on a weekly basis and bonds are falling, BUT the daily directional movements will be the opposite, even though the magnitudes of the movements are not equal. So over a two month period lets say, the dollar may be Up and the bonds down. But on any given day the dollar may be up alot and the bonds up a little, then a day where the dollar falls a little and bonds fall alot. Obviously, this is a situation where the dollar is rallying on days where the bond is retracing it's fall and then retracing on days where the bonds are resuming their descent. But what would that tell us about the economy and activities in other markets? Etc., that is the line of reasoning anyway.

8) When I talk about rules i mean such as this. In an accelerating economy the relationship between the dollar, bonds, oil, & stocks is such & such. In a decelerating economy the relationships are such & such, at the peak they are such & such, and if the economy is contracting they are such and such. Etc. A full understanding of rules like this would allow us to fully understand the markets and the economy in real time. We would understand that this is not a correction in this market and a reversal in that one, etc. That approach would eliminate alot of guess work, for me at least.

Do you do any Elliott or Fibanocci work?

 

[claywilk]

2cents,

Perhaps this chart will give you a better idea of where I am going. It is a very rough draft that will need to be worked on a heckuva alot more. However, if you look closely you will notice that there are periods where the dollar and interest rates move in convergent and divergent patterns. Sometimes the magnitudes of comparable movements are greater or lesser than they are at other times. Also when you delve deeper you will find that within the different markets can, on a daily basis be acting convergent while the larger trend is actually divergent. It is clear that a convergence of the dollar and interest rates occurs during economic acceleration and a divergence occurs during periods of deceleration/contraction. of course the opposite being true when you look at dollars versus bonds rather than rates. This is a broad example of the type of rules I'm looking for.

 

[Traden4Alpha]

Quote from claywilk:

While the starting place is econometric modeling, my ultimate goal is to be able to look at the markets in real time and see the business cycle, see the one market out of sync, know the inter-market relationships well enough to KNOW which ones are correcting and which ones are reversing, be able to look at the bond market, stock market, currency markets, and energy markets and know exactly where I am in the business cycle by their interplay.

You might start looking at cross-correlations with lags of weeks, months, even years. I recall Victor Niederhoffer talking about this with brokerage stocks vs the S&P. On the time scale of months, the S&P did well in the months after brokerage stocks did well. But on the time scale of a year, the S&P went down after brokerage stocks went up.

The real-time angle is very interesting because the the true underlying business cycle does doesn't vary in real-time. It takes weeks, months, even years for the impacts of the economic decisions of buyers to flow completely through the system. But the market's perception of the business cycle does vary in real-time.

I'd argue that your challenge is two fold. 1) identifying the true phase of the slow-varying cycle to identify which markets are moving nicely. 2) Applying cycle-based rules or relationships to catch profitable real-time variations in the perception of the cycle.

Quote from claywilk:

I am not looking for pat answers to complicated questions nor simplistic uni-directional supply/demand mumbo jumbo.

I hope this doesn't count as simplistic uni-directional supply/demand mumbo jumbo, but as far as creating hypotheses about which markets lead and lag each other, you do need to think about the flow of goods and money. In this regard, retailers see the money first when the economy is starting to turn for the better, then the consumer goods makers, then the cap-ex goods makers.

Companies don't build new factories until they see real evidence of high demand. And when demand dies, they often are reluctant to turn-off capital projects until thing get really bad. When things are bad enough demand for capex equipment goes to zero. Note: I've see at least three case studies that show that the capex equipment makers both lag the industries they sell to and get whipsawed pretty badly during the business cycle.

As far as fx is concerned, you might think about the money flows. If a Wal-Mart sells a Chinese DVD player, when does (did) the player's maker get the dollars and when did they trade it for Yuan? I'd imagine that fx cycles are a bit messy due to U.S. government deficits. These deficits lag the economy because tax collection lags the economy.

Quote from claywilk:

I am not looking for pat answers to complicated questions nor simplistic uni-directional supply/demand mumbo jumbo. I am looking for answers that you will not find in books because the people that know it have no need to publish it. I want to truly understand the economy and its various market in real time.

The trick with all of this business cycle theory is that every quant knows this and I'm sure a bunch of people (hedge funds et al) have computed every possible cross-correlation and are trading on it. The effects of this might be quite interesting, and also tradable. Suppose some group of traders have decided that market 1 leads market 2, what do they do? They buy market 2 when they see market 1 rise (perhaps with some minor confirmation in market 2). But some percentage of the time, market 1 would have a fake move and then revert. The anticipated move in market 2 would not progress because market 1 actually never moved into a sustained up-cycle. Yet the trades occur in market 2 as triggered by the fake move in market 1. The detectable result would be a shortening of the lag between the two markets and a increase in the correlation of volatility between the two markets. Instead of a nice smoothed lag between the two markets, we would see volatility in market 2 spike after moves in market 1. You might find some interesting patterns by cross-correlating volatility among various markets and various lags

Good luck!

 

[claywilk]

Hey Traden4Alpha,

Great to hear from you. I have commented some on your comments and look forward to hearing more from you!

Traden4Alpha says;
"The real-time angle is very interesting because the the true underlying business cycle does doesn't vary in real-time. It takes weeks, months, even years for the impacts of the economic decisions of buyers to flow completely through the system. But the market's perception of the business cycle does vary in real-time."

Would you say that a Soros Reflexive Action may apply here in that a markets perception of the business cycle have a profound effect on the business cycle? And that in the aggragate this happens over and over to the point that it has become one of the factors that also determine the lag with which impacts on the market are made?

Traden4Alpha says;
"I'd argue that your challenge is two fold. 1) identifying the true phase of the slow-varying cycle to identify which markets are moving nicely. 2) Applying cycle-based rules or relationships to catch profitable real-time variations in the perception of the cycle."

Exactly

Traden4Alpha says;
"I hope this doesn't count as simplistic uni-directional supply/demand mumbo jumbo, but as far as creating hypotheses about which markets lead and lag each other, you do need to think about the flow of goods and money. In this regard, retailers see the money first when the economy is starting to turn for the better, then the consumer goods makers, then the cap-ex goods makers. Companies don't build new factories until they see real evidence of high demand. And when demand dies, they often are reluctant to turn-off capital projects until thing get really bad. When things are bad enough demand for capex equipment goes to zero. Note: I've see at least three case studies that show that the capex equipment makers both lag the industries they sell to and get whipsawed pretty badly during the business cycle."

Yes, and these things are somewhat observable in money aggregates and other raw data. However, i believe that at some point your understanding of these and how they affect the market can be obtained by looking at the market with no need to pour over raw data.

Traden4Alpha says;
"As far as fx is concerned, you might think about the money flows. If a Wal-Mart sells a Chinese DVD player, when does (did) the player's maker get the dollars and when did they trade it for Yuan? I'd imagine that fx cycles are a bit messy due to U.S. government deficits. These deficits lag the economy because tax collection lags the economy."

I will put some thought into this for sure.

Traden4Alpha says;
"The trick with all of this business cycle theory is that every quant knows this and I'm sure a bunch of people (hedge funds et al) have computed every possible cross-correlation and are trading on it. The effects of this might be quite interesting, and also tradable. Suppose some group of traders have decided that market 1 leads market 2, what do they do? They buy market 2 when they see market 1 rise (perhaps with some minor confirmation in market 2). But some percentage of the time, market 1 would have a fake move and then revert. The anticipated move in market 2 would not progress because market 1 actually never moved into a sustained up-cycle. Yet the trades occur in market 2 as triggered by the fake move in market 1. The detectable result would be a shortening of the lag between the two markets and a increase in the correlation of volatility between the two markets. Instead of a nice smoothed lag between the two markets, we would see volatility in market 2 spike after moves in market 1. You might find some interesting patterns by cross-correlating volatility among various markets and various lags"

Most of my observations and success using intermarket relationships have convinced me that there are not really any lags to speak of. looking at the markets more often makes them look like a set of guages on a dashboard. A Great example of this is by looking at the dolllar and bonds in recent weeks. The 2 markets are in a divergent setting. The dollar had been rallying but has retraced that rally. Alternatively the bond market has been falling but in recent days have retraced that fall. If all the market conditions and correlations are intact, and we are not a point of transition to more convergence, then one of these may break slightly before the other. For instance, as soon as the dollar breaks and resumes its uptrend it may reinforce the notion that the bond is on the verge of resuming its downtrend. On the other hand, if the dollar resumes its uptrend and the bond follows we will be put on notice that the underlying fundemantals ( or at least the stronger part of the markets perceptions of the underlying fundementals) are in transition. If this is confirmed by other intermarket convergences/divergences then we know exactly where we are and can take action on which ever market our techinical analysis tells us offers the greatest risk return.

Good luck to you as well!

 

[Traden4Alpha]

Quote from claywilk:

Hey Traden4Alpha,

Great to hear from you. I have commented some on your comments and look forward to hearing more from you!

Thanks. It's always nice to find another thoughtful person

Quote from claywilk:

Would you say that a Soros Reflexive Action may apply here in that a markets perception of the business cycle have a profound effect on the business cycle? And that in the aggragate this happens over and over to the point that it has become one of the factors that also determine the lag with which impacts on the market are made?

Yes, although the effects can subtle depending on two broad factors. First, the market price trajectory can affects people's behavior, but it depends on how much the customers (and managers of the company) are impacted by market price cycles. I'd bet that companies that make heavy use of stock-options and stock-grants are more reflexive in the sense that if the company's stock price declines, the workers and managers because less energetic and less productive which leads to further declines at the company. Similarly if the customers are highly connected to the stock market, then good-times begat good-time. In contrast, I'd bet there are some companies (and customer demographic groups) that are totally ignorant of the stock & fx market and thus their behavior is less reflexive.

Second, the market cycle affects access to capital to create reflexive effects. In the down-side of the cycle, companies tend not to do IPOs and thus have fewer avenues for getting needed capital for funding growth. IPOs peak during the peak of the growth cycle (irrational exuberance lets all sorts of companies IPO) -- so equity financing creates strongly reflexive effects. The business cycle also has reflexive effects on debt-financing, but they might be more subtle. Debt financing can peak when interest rates are lowest (to stimulate growth) which tends to occur more at the bottom of the cycle. I'd still argue this is somewhat reflexive because the company needs to have some evidence that it can take on more debt in order to get a low interest-rate on its bonds.

Quote from claywilk:

Yes, and these things are somewhat observable in money aggregates and other raw data. However, i believe that at some point your understanding of these and how they affect the market can be obtained by looking at the market with no need to pour over raw data.

That is true -- the fundamentals should bleed through into the price action. At one level, traders don't care about the fundamentals except that they impact price action, but if they impact price action, then why not just watch that. But I would argue for an understanding the underlying economic flows for two reasons.

First, understanding the true connections in the economic system helps one generate hypotheses about the cyclic convergences and divergences in the price action -- that the fundamentals of one market will lead or lag that of another market and how the two oscillate during the cycle. This helps a trader avoid indiscriminate attempts to find statistical patterns. Knowing that the fundamentals of two markets are tightly coupled (versus inversely coupled) changes how the trader interprets divergences and convergences in price action.

Second, understanding the fundamentals helps the trader understand the micro-variations in the perception of the business cycle versus the actual cycle. Understanding why a given piece of news is "good" or "bad" and contrasting that news with the price action can say a lot about how other traders are perceiving the cycle. But unless one understands the fundamentals, one can't judge the discrepancy between news and price.