In response to “Exploiting Chicago Fed NFCI Predictive Power”, which tests practical use of the Federal Reserve Bank of Chicago’s National Financial Conditions Index (NFCI) for U.S. stock market timing, a subscriber suggested combining this strategy with stock market trend as in “Combine Market Trend and Economic Trend Signals?”. To investigate, we use the 40-week simple moving average (SMA40) for the S&P 500 Index to measure stock market trend. We then test two strategies that are each week in SPDR S&P 500 (SPY) or cash (U.S. Treasury bills, T-bills), as follows:
- Combined (< Mean): hold SPY (cash) when either: (a) prior-week S&P 500 Index is above (below) its SMA40; or, (b) prior-week change in NFCI is below (above) its mean since since the beginning of 1973.
- Combined (< Mean+SD): hold SPY (cash) when either: (a) prior-week S&P 500 Index is above (below) its SMA40; or, (b) prior-week change in NFCI is below (above) its mean plus one standard deviation of weekly changes in NFCI since the beginning of 1973.
The return week is Wednesday open to Wednesday open (Thursday open when the market is not open on Wednesday) per the NFCI release schedule. SMA40 calculations are Tuesday close to Tuesday close to ensure timely availability of signals before any Wednesday open trades. We assume SPY-cash switching frictions are a constant 0.1% over the sample period. Using weekly NFCI data since January 1973, weekly S&P 500 Index levels since April 1992, weekly dividend-adjusted opens of SPY and weekly T-bill yield since February 1993 (limited by SPY), all as specified through April 2020, we find that:
The following table compares net performance statistics for:
- SPY – buying and holding SPY.
- Change in NFCI < Mean – partial strategy 1(b) above.
- Change in NFCI < Mean+SD – partial strategy 2(b) above.
- SMA40 – partial strategy 1(a) and 2(a) above.
- Combined (< Mean) – combined strategy 1 above.
- Combined (< Mean+SD) – combined strategy 2 above.
Statistics include: sample length; percentage of weeks in SPY; average weekly return; standard deviation of weekly returns; worst week; number of SPY-cash switches; compound annual growth rate (CAGR); maximum drawdown; and, annual Sharpe ratio using average weekly T-bill yield during a year as the risk-free rate for that year and treating 1993 as a full year. Notable points are:
- SMA40 has a much shallower maximum drawdown and a modestly higher Sharpe ratio than SPY, at the cost of some CAGR.
- Combining SMA40 with NFCI-based signals does not improve performance for any performance metrics. The top-performing strategy based on CAGR is Change in NFCI < Mean+SD. The top-performing strategy based on maximum drawdown and Sharpe ratio is Change in NFCI < Mean.
Using a 44-week SMA to approximate a 10-month lookback more precisely makes little difference.
For perspective, we look at cumulative performance.
The following chart compares on a logarithmic scale cumulative net values of $10,000 initial investments in Change in NFCI < Mean and Combined (< Mean) over the full sample period. Notable points are:
- Differences in general trajectories are modest.
- Combined (< Mean) presents a bumpier ride than Change in NFCI < Mean, because it is in SPY much more often.
In summary, evidence does not support belief that adding a simple trend signal to signals from weekly changes in the NFCI improves U.S. stock market timing performance.
Cautions in “Exploiting Chicago Fed NFCI Predictive Power” mostly apply, and the selected SMA lookback interval may inherit data snooping bias from prior tests.
Frequently Asked Questions
What is the Chicago Fed National Financial Conditions Index (NFCI)?
The Chicago Fed National Financial Conditions Index (NFCI) is a weekly index published by the Federal Reserve Bank of Chicago that measures conditions in U.S. financial markets. In the article, weekly changes in the NFCI serve as a U.S. stock market timing signal, with the prior-week change compared to its mean since the beginning of 1973 (or its mean plus one standard deviation).
Does adding a trend signal to the NFCI improve stock market timing?
Combining a 40-week simple moving average (SMA40) trend signal with NFCI-based timing does not improve performance on any metric versus NFCI signals alone (February 1993 to April 2020, weekly SPY/cash switching). The best CAGR came from the NFCI change below mean plus one standard deviation strategy, while the NFCI change below mean strategy had the best maximum drawdown and Sharpe ratio. Using a 44-week SMA instead of 40 weeks made little difference.
How do you build a strategy that combines a moving average and the NFCI to switch between stocks and cash?
The strategy holds SPDR S&P 500 (SPY) or cash (T-bills) each week, holding SPY when either the prior-week S&P 500 Index is above its 40-week simple moving average or the prior-week change in the NFCI is below its threshold (mean, or mean plus one standard deviation, since 1973). Returns run Wednesday open to Wednesday open, SMA40 is calculated Tuesday close to Tuesday close so signals are available before trading, and switching frictions are assumed at a constant 0.1%. Performance is evaluated using CAGR, maximum drawdown, and annual Sharpe ratio.
How does a 40-week moving average strategy compare to buy-and-hold SPY?
The SMA40 strategy had a much shallower maximum drawdown and a modestly higher Sharpe ratio than buy-and-hold SPY, at the cost of some CAGR (February 1993 to April 2020). Combining SMA40 with NFCI signals made the ride bumpier than NFCI alone because the combined strategy is in SPY much more often.
What are the risks of relying on moving average and NFCI timing signals?
The cautions from the NFCI timing test mostly apply to the combined strategy, and the selected SMA lookback interval may inherit data snooping bias from prior tests. Results also depend on the specific sample (SPY data from February 1993 through April 2020) and an assumed constant 0.1% SPY-cash switching friction.