Squaring your delta: URI-200 breaks negative

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URI (Ultimate Risk Index) is an indicator Brent & I developed to determine when the tide had turned against the risk-seeking trade.

It is calculated by summing the number of markets (we look at 23 global indices) which are within the top quartile of 2-stdevs from the past 100 days, and then subtracting the number of markets which are within the bottom quartile.

Additionally, we punish the end-value of the indicator if the yield-curve is close to or negative.

We use two variants: URI-1 (not smoothed), and URI-200 (smoothed with a 200-day moving average).  Clearly, URI-1 is very sensitive, while URI-200 is used for longer-term context.  It is designed to be long, deliberative & slow for maximum signal value.  A lot of our other algorithms key off this to decide whether to go to cash, or even go short.

As you can see, the URI-200 has finally pushed into negative territory.

What does this mean?  It doesn’t necessarily mean instant death and destruction — in fact, it often has coincided with some short-term rallies in the past, such as in 2008.  But, ultimately, it is telling us to concentrate on preserving our account balances in the face of our persistent optimism.

I still don’t see the kind of economic breakdown which presaged the previous recessions depicted.  The market sentiment was decidedly more complacent during both periods.  The Equity Risk Premium was 1/3rd of what it presently is.  The VIX was 10-15 points lower.  Yields were far from their all-time lows.  Moreover, after muddling through, it now appears fairly unlikely that the Germans will allow their monetary & financial system to fail via the “leveraged ESFS 2.0 with ECB backing” plan.  That makes me still want to own equities.

Capital preservation compels us to keep our delta closer to our chest, however.  The question is how.  Given the view on equities being cheap even in a mild recession (13.6x 2012 EPS at a pessimistic $85;  $95 or better likely for 2011), shorting equities is a really unattractive proposition, particularly when SPY is yielding 4bps more than the 10y UST.  Bonds are extremely expensive with record low yields at nearly every duration.

The risks we are protecting ourselves from are unlikely tail risks — principally:

  1. Will China let its cool-down continue, and perhaps more critically
  2. Will the European financial system or sovereign explode

So, we want to weight heavily on assets which don’t have those assumptions already at least partially baked in.

Our preference for sometime has been to periodically rebalance a basket of save-haven assets weighted on cheapness.  Shorting Australian & Canadian dollars present favourable hedges to our portfolios, and we’ve recently implemented this beta-adjusted as our largest gamma-long positions.  Next in queue is Gundlach’s Total Return fund, and finally a smattering of gold, Build America Bonds and long-dated Treasury bonds.
 
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The idea is that AUD provides a proxy to both Chinese and European growth, and the CAD more generally to the commodity trade.  It is also likely that both central banks will cut interest rates in the next 6-12 months due to domestic weakness.  The CAD in particular has been a modestly reliable hedge for US equities:  it has been very muted on the up-side, and very weak on the down-side.

We’ve still got some delta to the S&P 500 (about 35%), and we like it that way.  We’ve tried to construct a portfolio which has asymmetric risk/reward profiles for both the longs and the shorts, and it’s been an effective strategy.

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4 Responses to Squaring your delta: URI-200 breaks negative

  1. Erik Swarts says:

    Interesting stuff Matt. Curious what the indicator would show for the last sovereign debt crisis in 98. Have you brought it back that far?Take care.

  2. Zippertheory says:

    Hi Erik, Thanks for the note. We stretched the indicator back much further than 1998, but 10 years or so is the standard viewing size so that is all we posted. We take another screen shot and post it here shortly. Thanks,

  3. Alex says:

    Hi, very interesting stuff, could you elaborate a bit on the construction of the indicator? thank you

  4. Alex says:

    just wanted to add that I find it particularly interesting that the indicator flashing seemed to often be followed through by a sell-off; hence understanding the construction seems interesting. Thank you again

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