Prisma Newsletter: June 2023

Spotlight of the month: A simple Fed Net Liquidity Indicator

This month, Prisma’s investment research was focused on the Fed’s monetary intervention, and in particular the liquidity it provides and its influence on equity returns.

We base our analysis on the Fed Net Liquidity index, which measures the money supply provided by Fed’s purchases of government bonds and thus provides an indication of the liquidity it generates in the economy and the markets in particular. As the equity markets commonly receive excess of liquidity, the Fed Net Liquidity index could have a major impact on short- and medium-term returns on these markets.

To compute this index, we consider 3 components.

This formula makes it possible to assess how much of the total quantity of liquidity supplied by the Fed is actually in circulation in the economy and is therefore likely to end up in the equity markets and drive them up. These 3 components are shown below. We can clearly see that while the TGA and RRP played a minor role before 2020, their use (and therefore their impact) exploded after the Covid-19 crisis, making their consideration essential for any analysis of the Fed’s monetary intervention.

Once we have calculated our Fed Net Liquidity index, we can compare it with the performance of the S&P 500 index since 2008. We can see that this index has been increasingly correlated with the S&P 500 index, and we can therefore assume that some of the S&P 500 index’s short- and medium-term returns are driven by changes in Fed Net Liquidity.

The following graph zooms in on these two indices over the recent period (since 2020), adding the 3-month moving average of the Fed Net Liquidity index. This graph confirms our initial impression: since 2020, the Fed Net Liquidity index has provided information on short-term equity market movements.

We can therefore try to develop a simple dynamic investment strategy based on trends in the Fed Net Liquidity index. For this example, we are going to test a very simple investment strategy: long the S&P 500 index if the Fed Net Liquidity indicator is above its 3-month moving average, long cash otherwise.

Without getting bogged down in statistical analysis, which would be slightly superfluous for such a short analysis period, we can say that such an investment strategy would have made it possible to avoid almost all the drawdowns of 2022. This simple strategy confirms that the Fed Net Liquidity index is something to keep an eye on.

To conclude this short overview of the Fed Net Liquidity Index, let us look at the S&P 500 index/Fed Net Liquidity ratio, which gives a rough idea of the current trend in the flow of liquidity into the equity market.

We can see that this ratio is in the process of crossing a bullish peak, which could imply that the S&P 500 is overpriced relative to available liquidity. The near future will tell whether this trend reflects an imminent fall.

Prisma Risk Indicators: Insights into Performance

Performance

Note: To establish a meaningful comparison in terms of risk assessment and performance evaluation, a benchmark portfolio comprising 50% S&P 500 and 50% cash has been selected. This choice is based on the historical realization of volatility, which aligns with an exposure timed using Prisma risk indicators.

Comment: For the first time since late 2021, the ERIC (average risk level of Prisma risk indicators) has exhibited a predominantly low risk level (below 25%, indicated by the white area) throughout June. This observation proved to be accurate, as the S&P 500 experienced a substantial 6.5% increase during the month. Once again in 2023, our risk indicators are providing valuable insights by correctly identifying the market rebound. Throughout the year, they have consistently indicated low to moderate risk levels (white or light pink area) compared to 2022, when the indicators predominantly showed high or very high risk levels (pink or red area).

Relative Performance

Comment: The relative performance analysis of the S&P 500, timed using the Equity Risk Indicator in relation to a benchmark portfolio consisting of 50% S&P 500 and 50% USD cash, reveals the following insights:

• March 2020: Prisma risk indicators accurately identified the market panic sell-off, reflecting a very high risk level. This prompted a significant underweighting of equity exposure, resulting in strong outperformance during this period.
• June 2020 to December 2021: Prisma risk indicators successfully recognized the bull market by consistently indicating low risk levels. This led to an overweighting of equity exposure, contributing to a substantial outperformance over this period.
• February 2022 to April 2023: Prisma risk indicators identified moderate to very high risk levels. Specifically, very high risk levels were observed in May 2022 and September 2022, while the remainder of the year was categorized as moderate or high risk. Consequently, the equity exposure remained neutral for most of the year, except in May and September when it was significantly underweighted. This explains the relative performance remaining relatively flat during this period, except a spike in September.
• Since the end of April 2023: Prisma risk indicators have identified low to moderate risk levels, leading to an increased equity exposure. This strategic adjustment has allowed for outperformance, capitalizing on the strong market rebound.

Overall, the analysis demonstrates the valuable role played by Prisma risk indicators in accurately identifying market conditions, guiding portfolio allocation decisions, and ultimately impacting relative performance.

Risk-return scatter plot

Let’s delve deeper into the Prisma risk indicators by examining the risk-return plot below. This plot provides a comprehensive comparison between the various Prisma risk indicators, the S&P 500 index, and ERIC (Equity Risk Indicator), which represents the average of all individual Prisma risk indicators. It is worth noting that the analysis covers the period from Alquant’s inception on March 31, 2023, up until the end of June 2023. In this evaluation, we have taken into account transaction costs of 0.05% to ensure a comprehensive assessment of performance.

The Prisma risk indicators demonstrated remarkable effectiveness in reducing the volatility of the S&P 500 index. Among the seven indicators, an impressive five of them displayed superior risk-adjusted performance in comparison to any combination of the S&P 500 and USD Cash (represented by the Grey dotted line). Notably, the Vega and Crossvol indicators stood out by not only effectively reducing volatility but also surpassing the performance of the S&P 500 index itself.

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Disclaimer: This content is advertising material. This content as well as all information displayed on Prisma or any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.