Bond trading volume exploding in anticipation of a big change?

We have seen a near-term positive reversal for TLT, the long bond ETF, but what is surprising is the large increase in trading volume in October and early November. TLT was exceeding volume levels from the March 2020 debacle. Everyone wants to trade the long bond and get in on what some may expect is the big reversal. 

Perhaps the market is normalizing but there is still significant upside potential in bonds if a recession materializes and the Fed decides to lower rates. Those are big ifs, but that is the bet many have been making. 

Hat tip "Rudy Havenstein from A Havenstein Moment." <rudy@substack.com>

So where is the recession? The PMI and LEI say watch-out

There are two classic leading indicators for recession from real economic data. One, the NAPM PMI reading suggests a recession and/or a significant slowdown if the value of the index is below 50. Two, the Conference Board LEI index is falling consistently on a year-over-year basis. 

In the case of the PMI, we have been below 50 for over a year with the current reading again turning lower at 46.7. The Conference Board leading economic indicator index topped in early 2022 and has been falling ever since. By these measures, we should see a marked decline in risk-on assets, yet 2023 has been a positive year. Being early to a recession trade has not been helpful. 

Measure the direction of stocks and you can create value

Sometimes simple is the best approach to generating returns. Forget complex models and just focus on the direction of markets. In the paper "Directional Information in Equity Returns", researchers shows that there is sign predictability in equity returns. Look at some sequence of equity returns and you will be able to capture investor optimism and pessimism which can tell us something about stock direction. 

A set of stocks can be ranked based on the likelihood of direction to form a long-short portfolio. Buy the stocks that have a high likelihood of a positive move and sell those that have a high likelihood of a decline. 

Just sorting by directional likelihood may be able to do a better job than a traditional momentum portfolio. In fact, over the period 1991-2022, a directional portfolio will don better than a traditional momentum sorted portfolio. Over the longer-term 1932-2022, these two portfolios will give similar results. Just focus on direction and the rest may take care of itself. 

Alternative risk premium - Offers diversification if you pick the right mix

 

Alternative risk premia (ARP) strategies can be divided into offensive and defensive categories. The offensive strategies will perform better in risk-on environment and defensive strategies will do better during risk-off environments. In other words, offensive strategies will do better when equities are higher while defensive strategies will do better in bond positive environments. There is more to holding ARPs than looking at the unconditional correlations.

The paper "Does Alternative Risk Premia Diversify? New Evidence for the Post-Pandemic Era" analyzes the value of a diversified pool of ARPs to show their value in the post pandemic period. It finds that trend and commodities do a very good job of providing defensive diversification.

The key finding is that all ARPs are not the same. A simple unconditional or linear approach to analyzing ARPs will miss the value-added in up and down-market environments. Of course, investors have to form a view on the future direction of the markets to fully take advantage of the conditional behavior in ARPs.