By Michael A. Gayed
And now for something completely different.
I can certainly sympathize with most who believe markets are like a legalized casino game, especially with the way volatility has clipped both bulls and bears this year. Many would argue market timing is impossible and that predicting is a fool's game. No one can see the future, and yet investing is ultimately a bet on a non-present condition. To get to our destination, we must drive forward, and not rely on a rearview mirror. Why even bother trying to analyze markets, right?
“With most people disbelief in a thing is founded on a blind belief in some other thing.”
Georg C. Lichtenberg
As much as I write about markets and put a spotlight on disconnects, I actually don't necessarily disagree. The long-term is nearly impossible to predict. However, there is academic research that suggests that it is possible to predict the near-term. In other words, the short-term is more observable than the long-term. Just like driving, we can see what traffic is likely to be a mile from now because we are able to see the road ahead of us up to the edge of the horizon. I have no clue what driving conditions will be 5 miles from where I am, but have a high degree of certainty over that which is directly ahead of me. I can speed up or slow down my driving based on that.
Let's take the analogy a step further. We can see a looming cloud on the horizon, but it hasn't started to rain yet since the car is just outside the periphery. However, as we edge closer to the cloud, we can see if it’s going to rain or not. The cloud dictates weather conditions, which dictate the speed at which other drivers drive, and ultimately how fast one should proceed down the highway. Traffic ultimately occurs because the conditions surrounding drivers cause them to either slow down (rain/stormy clouds), or speed up (all-clear on the road, weather conditions fine).
What does any of this have to do with the stock market and with my headline of Dow 67,585.69? If you agree that the short-term is more observable than the long-term, and that the conditions dictate how fast one should drive (how much risk one should take to get to the end destination), then allow me to offer you some proof that one could indeed have significantly outperformed buy and hold by identifying the trend in underlying inflation expectations. The fundamental premise is that the conditions dictate how the future could play out.
Having said that, think about "predicting" not in terms of markets going up or down, but rather in terms of the speed at which returns fluctuate (volatility). We continuously hear in the financial media the terms risk-on and risk-off as a way of describing market movements. Note that just a few years ago such rhetoric describing stocks never existed, but never mind that. Broadly speaking, risk-on means stocks are doing well and likely better than bonds, and risk-off means the opposite. Risk-on = stocks (more volatility), risk-off = bonds (less volatility).
If this is indeed the right way to interpret what those terms mean, then naturally one can assume that risk-on also means that inflation expectations are rising (deflation expectations are falling), and risk-off means inflation expectations are falling (deflation expectations are rising). After all, if you expect inflation to rise, bonds with their fixed coupons would not be the kind of investment necessarily you'd want to hold on to for the future. If you expect inflation to fall, you'd want to lock in those higher coupons now as prices around you fall and the economy weakens. Note that this is not a guarantee whatsoever - the point is to suggest that if inflation expectations are rising/falling, the conditions likely favor stocks/bonds.
Notice that I am stressing here "expectations" - what matters is not what actual inflation is now but what the crowd thinks about inflation going forward. As such, persistence in the trend of inflation expectations ultimately drives asset returns relative to one another. They dictate if the conditions favor being risk-on, or risk-off. This should make some sense. Even from an economic standpoint, a steepening yield curve (inflation expectations over time rising due to better economic growth) is considered a leading indicator for the economy. This can be extended into the asset allocation decision.
This is not something I am saying without backing up. Take a look below, which shows how a strategy designed around inflation expectations and identifying underlying conditions could have resulted in Dow 67,585.69.
The blue line is a simple buy and hold strategy of the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA +0.08% , assuming you bought the index in January 1929 at a level of 315.13. The "Risk-On/Off Buy and Rotate Strategy" assumes the following:
Risk-On means you go 100% into the Dow Jones Industrial Average, tracking the index as the proxy for broad exposure into the stock market (higher volatility).
Risk-Off means you go 100% into the Dow Jones Utility Average /zigman2/quotes/210598062/delayed DJU +0.11% tracking the index as the closest version of the bond market in stock form (lower volatility).
What determines which index is tracked is dependent purely upon inputs that gauge if inflation expectations are rising or falling (the secret sauce).
Data uses weekly prices, and does not assume anything related to taxes, costs, slippage, etc - it as if I have created an index of two indices.
And of course past performance is not indicative of future results.
Note that I am using the Dow Jones Utility Average as a proxy for bonds because among all sectors in the stock market, Utilities most closely behaves like the bond market given high dividends and relatively lower volatility. Investors concerned about a slowdown in the economy and deflation going forward will generally overweight Utilities given dividend appeal, and underweight the sector when economic growth and inflation expectations are rising.
So yes - the conditions do matter, and can be modeled historically. More so than that, there does appear to be a way to "predict" which asset class has a better chance of outperforming so long as inflation expectations trend in some way shape or form. That's how you could have gotten to Dow 67,585.69 from a back-tested perspective. If risk-taking occurs under conditions where market participants believe inflation expectations are rising, then the underlying thought process is robust because of a true causation underlying investor behavior.
The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.