Thread by @policytensor

An illustrated guide to the global financial cycle. 1/ 👇

How can we measure global financial conditions in real time? The strategy pursued by the Chicago Fed in the construction of the National Financial Conditions Index (NFCI) is problematic, as I explained here. policytensor.substack.com/p/how-to-const… 2/

Instead of trying to track the NFCI, we let the covariation with market returns determine the loadings for each of the risk spreads we use to construct our metric. We use the PLS estimator to obtain the linear combination of risk spreads that best tracks the market. 3/

A major question is how to obtain the metric in real-time, ie with data available at time t. We use expanding window PLS, & normalize the metric such that the range of variation over [0,t] is [0,1]. Zero indicates that financial conditions are tighter than ever, 1 the opp. 4/

Here's our real-time measure of the global financial cycle. We have marked out the dot-com bust, 9/11, Bear Sterns collapse, Lehman, 'whatever it takes', and the coronapanic. The metric tracks all these events in real time. 5/

The exercise reveals the tidal whipsaw of the global financial cycle. Financial conditions are GLOBAL, not local, as @helene_rey has shown, and as we argued here: policytensor.substack.com/p/the-global-f… 6/

This also allows us to examine the effect of QE on the GFC. The dotted lines show the weeks where the Fed bought >$50b bonds. We can see immediately that QE worked in easing global financial conditions, all three times. 7/

What the metric captures in essence is the price of systematic risk in global markets. When financial conditions are loose and risk appetite is high, the price of risk collapses; when financial conditions are tight and risk appetite is low, the price of risk increases. 8/

What can investors do with this information? If you know the price of risk in real time, you can make a lot of money of this information on the systematic factor. 9/

A simple rebalancing strategy where you overweight risk assets in your portfolio when the price of risk is high (financial conditions are tight), and sheds risk when the price of risk falls, beats the buy-and-hold strategy without taking any more risk. 10/

The beauty of this systematic strategy is that u don't need any leverage. U can lever up if u want. But u don't have to. U can beat the SP500 while capping your downside risk by the SP500! This is the key to strategic asset allocation: policytensor.substack.com/p/strategic-as… 11/

The bottomline is that the signal is god. Everything is secondary. If you can isolate the signal, you can beat the market by identifying the dynamic mispricing of risk. The key is to know when to hold the power dry: modul.repo.mercubuana-yogya.ac.id/modul/files/op… 12/12

How much money does strategic asset allocation make? We compare (1) holding SPX, (2) holding 50-50 SPX and the Bill, (3) strategic asset allocation, suppose u put in 100 dollars in each of these strategies on Feb 28, 1999 and reinvested. How much would you have by now? 13/12

You'd have $248 if you held the SPX; $200 if you held the 50-50 portfolio; and $429 if you followed my strategic asset allocation strategy. Not bad @crossbordercap? 14/12

The mean annualized returns? SPX: 4.2%, 50-50: 3.2%, Strategic Asset Allocation: 6.8%.

The Sharpe ratios? SPX: 0.36, 50-50: 0.48, SAC: 0.93.

Note that SAC requires 0 leverage. U're just rebalancing in a highly informed manner. 15/12