Multiasset-class investing strategies today must combine upside participation with downside protection, the so-called holy grail.
From 1980 to 2000, investors could have placed 60% of their assets in an equity index and 40% in a bond index, fallen asleep for 20 years and awakened to discover the portfolio had appreciated by more than 10% per year. Eureka! Since 2000, however, the experience has been quite different, as the same portfolio twice has endured drawdowns in excess of 30%. A new approach is needed.
What caused this change and how should investors respond?
The Bank for International Settlements, in its 85th Annual Report (a top-10 reading for all investment professionals), zeroes in on the sources of financial instability. Historically, macroeconomists have built models around the belief that if inflation remains in check, financial stability naturally tends to follow. Fortunately for all of us, the BIS, in its annual reports, takes a different approach. Its view is that, especially when inflation is dormant, other imbalances (excessive debts, elevated debt service to income and overvalued assets) tend to build until they can no longer be sustained, at which time they reverse. Financial market booms in turn become busts. This boom-bust dynamic has become increasingly commonplace since financial markets were liberalized and deregulated, beginning in the mid-1980s. The so-called “Greenspan put” (which placed a movable floor on equity market valuations) artificially kept this dynamic in check for some time, but ultimately culminated in a far more severe financial collapse in 2008.
The BIS argues, correctly in our view, that discussions of macroeconomic stability must incorporate the financial (boom-bust) cycle. We agree with this “real world” assessment. Consistent with it, we have developed a “market state” concept. The market state perspective identifies macroeconomic and financial market indicators (macrofinancial indicators) that drive asset class valuations. These indicators can be combined using a statistical process to generate market states. The rationale for this approach is intuitive and reflects the current reality that asset valuations periodically decouple from underlying real economic activity. Finance is not “neutral” – it does more than simply facilitate productive activity. At times, financial markets anticipate events, leading real economic activity, either up or down. In other (“deflation scare”) circumstances, rapid credit growth and overly loose monetary policies propel asset price appreciation even as real economic growth remains weak (2009-2015). In this situation, the tendency for financial markets to decouple results in a disconnect between asset valuations and real economic activity that periodically triggers sharp reversals (as in 2007-2009), with significant losses to investors. In our view, a market state approach more effectively captures drivers of asset valuations than a static buy-and hold approach.