Volatility Trading With The Composite Leading Indicator

The composite leading indicator is produced by the OECD.

It is an index of components that pertain to each country and is considered a leading indicator of near-future economic performance.

The components for the CLI are:

• Component Series (Unit) Source
  
• Work started for dwellings sa (number)
  
• Net new orders - durable goods sa (USD)
  
• Share prices: NYSE composite (2015=100)
  
• Consumer - Confidence indicator sa (normal = 100)
  
• Weekly hours worked: manufacturing sa (hours)
  
• Manufacturing - Industrial confidence indicator (% balance)
  
• Spread of interest rates (% p.a.)
  

In this piece, we will look specifically at the CLI for the USA. However, I think it will work for most countries ultimately.

I consider you can use the CLI to accurately forecast slowdowns and volatility in US markets and sometimes outright recessions and crashes.

I have overlaid the CLI (the blue waves) with US recessions (red blocks) and added a 20 month SMA to it.

I have also added in dotted orange bands points where CLI takes out its own MA and moves below it which I consider being a "buy vol" signal.

To be clear, these dotted bands are not necessarily recessions, just slowdowns denoted by the composite leading indicator/MA tool. This does not mean however that they are not potentially good volatility trades (as we shall see).

We can see that out of 14 slowdowns and economic recessions. The CLI/MA has a very good success rate if we view it as a "buy" indicator for the VIX.

The buy points denoted by the orange dotted bands are:

• 1st May 1993
  

Was followed by a small VIX spike in 1994. A small win could have been achieved by buying vix at $12 and selling for $19 one month later returning over 50%.

• 21st December 1994
  

A longer-term hold. Buy signal triggered at around $12.50 and a hold would have been necessary. The positions started generating serious returns in 1996 and maxed out at around $32 in 1997 returning over 150% over 2 years.

• 1st May 1998
  

Buy signal was generated at around the $20 mark. This would have returned 100% gains just 3 months later during the VIX spike to over $43.

• 1st June 2000
  

Buy signal generated at the $21 mark. This was shortly before the dotcom bubble burst and this would have been a 1.5 year hold generating around 50% return when closed at the onset of the dotcom crisis or could have been held for a return above 90% in 2001 or well over 100% in 2002.

• 
  1st March 2002
  

An interesting dip on the VIX was called by the indicator here. Not sure if just a coincidence or not but it does look suspiciously neat-and-tidy. This triggered at $17.97 and then returned over 100% just a few months later in September of the same year equating to a 5-month hodl.

• - 1st Feb 2005
  

Peak of the post-2000 credit cycle. This trade was a hold. Indicator triggered at 12.01 and the best selling position was 2 years later in July 2007. Returning just under 100% or could have been held to generate bigger returns when the credit crunch kicked in during 2007 and the primary crash occurred during 2008.

• 1st November 2007
  

This is obviously the peak of the market for the housing bubble bull-run. The indicator triggered at $20.15 and the ensuing VIX spike maxed out at around $58 returning nearly 300% if the trade was closed one year later.

• 1st June 2011
  

A very close to the edge trade which triggered during the double-dip recession in the Eurozone. This is one of the less-good entries with a price of around $25. However, it is very very short term with VIX peaking at $42 over just a few months returning over 75%.

• 1st March 2015
  

The indicator triggers on around 1st of March of this year at around the $14 mark and is another medium-term trade with vix peaking at 28 just a matter of months later returning just under 100% as the onset of the Brexit/US Trade War grips market.

• 1st August 2018
  

Jitters are evident in CLI as far back as 2018 when the indicator fired and returned a buy price of £13.04. This could have been held for a short-term trade turning over 70% within a matter of months or held longer until the COVID pandemic in 2020 which I consider to have been one of the root causes for the VIX becoming elevated during this time. The longer-term hold would have returned over 400%.

As such, you can see that the crossovers between the CLI signal and the MA on a monthly chart usually preceded volatility bull markets, very serious short-term vix spikes and sometimes even outright recessions.

There are a couple of points to bear in mind here.


Signals sometimes appear up to a year before the "event". That's the whole purpose of this indicator. So in other words, you may have to be prepared to hold. As such, ETF decay which is inherent to instruments like UVXY must be factored in. This strategy is therefore more suited to de facto VIX rather than any of it's leveraged ETF variants.

There are a couple of so-called "false positives" with respect to this indicator calling an "event" very far ahead. For instance, in 2005 it gave a "buy signal" for volatility. This isn't necessarily "wrong" per se, because face it, you'd have been dumping your equities and taking on vol nearly at the very top of the market here. As such there is SOMETIMES ample opportunity to "buy n hold n accumulate". That's another reason why leveraged volatility may not always be suitable per se due to the fact of leveraged ETF decay.

On the other hand, there are some short-term opportunities herewhich are denominated in terms of only months. Leveraged products may be more suited to these.

I believe that we must exercise judgement if we are to implement this strategy and to judge the relative position of our entries relative to the market when choosing what instruments to employ to benefit from volatility spikes.

I believe this does demonstrate the validity of using CLI and other macroeconomic indicators for volatility investing.

Comment:

The OECD Composite Leading Indicators will be updated at 12h00 noon Paris time on:

17 January 2022
9 February 2022
8 March 2022
11 April 2022
10 May 2022
13 June 2022
11 July 2022
9 August 2022
12 September 2022
11 October 2022
9 November 2022
8 December 2022