Join our community of smart investors

Ideas Farm: Crystal ball gazing

Research from quant firm Verdad Capital suggests a straightforward way to help gauge the direction of the world’s leading economy.
Ideas Farm: Crystal ball gazing
  • Want to predict near-term economic conditions?
  • Here’s a trick to help
  • Loads of new idea-generating data

Wouldn’t it be great if you could predict where the world's leading economy was headed? As this column touched on two weeks ago (Happy First Birthday, 6 May), there is evidence that certain investment approaches thrive in the right economic conditions. 

To recap for non-forensic followers of this column (pains me as it does, I assume this to be the majority of readers): periods of economic recovery tend to be a sweet spot for value investing and small-caps; as an economic cycle moves into a growth phase, value and momentum tend to do best; as the cycle ages and slows, it is strategies based on quality, low volatility and momentum that are most likely to outperform; and when it comes to recessions, it is once again quality and low volatility that have a tendency to come out on top. All this is based on a study by Research Affiliates.

The smart people at small-cap quant firm Verdad Capital believe there is a trick that allows them to make a good guess about what the prevailing economic conditions in the US will be in the coming three months. What’s more, the indicator they use is relatively straightforward and easy to monitor, so should be of interest to private investors, too. 

Verdad suggests the so-called high-yield spread is the best macroeconomic forecasting tool out there and it's not alone in its enthusiasm. The spread refers to the difference between the interest rate offered by below-investment-grade corporate bonds and the corresponding rate for super-safe US Treasury bonds. It is information that is freely available for the US and eurozone from the Federal Reserve Economic Data (FRED) website.

What the spread tells investors is how easy it is for less-reliable businesses can get their hands on money. When spreads are low, it indicates that money is relatively cheap and readily available. When spreads are high, it suggests the opposite. The great thing is that spreads are forward looking and based on the judgements of the many players in the fixed income market. That means the information harnesses the collective analytical powers of some of the smartest forecasters and investors, who also have a lot of money riding on their judgements being good.

So how should one use this data?

Verdad suggests looking at just two things. Firstly, whether the current spread is above or below the median. And secondly whether the spread is tightening (suggesting increasing optimism about the economic outlook) or widening (increasing pessimism). A high-and-rising spread suggests recessionary conditions ahead, high-and-falling is synonymous with a recovery, low-and-falling spreads mean growth, while low-and-rising suggest the growth is set to slow while inflation is likely to run high. 

A back test conducted by Verdad that used the indicator to second guess markets and switch into appropriate asset classes, including commodities and fixed income, produced impressive long-term results. In the 30 years to 2020, the strategy boasted a compound annual growth rate of 14.5 per cent versus 10.3 per cent for the S&P 500 along with a maximum peak-to-trough fall of just 17 per cent versus 51 per cent. The trouble is, implementing such a strategy in the real world would create substantial turnover and all the costs and complications that come with that. 

For private investors, though, knowing the economic mood music is always helpful and any trick that offers insight is worth paying attention to. 

So where are we now? US and eurozone spreads are low and becalmed. That would suggest there is growth on the horizon or even the emergence of overheating. Perplexingly, though, it feels like we’re still waiting to see the recovery phase of the economic cycle. That said, stock markets have already extracted a good chunk of recovery upside.