Today\u2019s post looks at a recent paper from MAN on regime-based investing.<\/p>\n
Regime-Based Investing<\/span><\/h5>\nThe new paper (from February 2024) asks:<\/p>\n
\n- whether regimes can be identified in real-time (rather than just in hindsight, and more importantly,<\/li>\n
- if (and how) we can profit from correctly identifying them<\/li>\n<\/ol>\n
It\u2019s a follow-up to a 2021 MAN paper called \u201cThe Best Strategies for Inflationary Times\u201d.<\/p>\n
\n- I covered this as part of a series of articles I published that year on whether the traditional 60-40 stock\/bond<\/a> portfolio needed updating in the light of looming inflation.<\/li>\n<\/ul>\n
So before we look at the new paper, I\u2019ll recap what we learned in that series.<\/p>\n
Recap<\/span><\/h5>\nFirst, the basics:<\/p>\n
\n- Stocks are riskier (more volatile in price) than bonds but have higher long-term returns.<\/li>\n
- The logic of blending two assets together comes from the idea that their prices will move in different directions.\n
\n- When stocks go down, you hope that bonds will move up in price.<\/li>\n<\/ul>\n<\/li>\n
- The riskiest portfolio normally recommended by financial advisors to customers with differing levels of risk appetite would be 80-20 stocks\/bonds \u2013 and the safest would be 40-60\n
\n- So the 60-40 portfolio can be thought of as the middle option of three.<\/li>\n<\/ul>\n<\/li>\n
- Bonds are a pretty bad hedge for stocks in any case, unless you either hold a lot of them (bad for overall returns) or use a lot of leverage<\/a> (potentially risky, and not easy for private investors).\n
\n- However, the 60:40 portfolio is easy to understand and has proved pretty easy to market to investors.<\/li>\n
- It\u2019s also done pretty well over the decades, so many investors would miss it.<\/li>\n
- It was a decent choice following the 2008 crisis until the wheels came off in 2022.<\/li>\n<\/ul>\n<\/li>\n<\/ol>\n
The impact of inflation<\/span><\/h6>\n\n- If inflation rises for an extended period, this could be bad for both stocks and bonds.\n
\n- In quant speak, the bond<\/a>-equity correlation might turn positive (it did).<\/li>\n<\/ul>\n<\/li>\n
- This is actually the normal relationship, but in recent years, investors have become used to bonds rising when stocks fall.\n
\n- In particular, recession-driven stock market crashes lead to a demand for safe-haven assets, which are traditionally government bonds.<\/li>\n
- So the price goes up, and the yield goes down.<\/li>\n
- When the economy recovers, so do stocks, but bond<\/a> prices fall back.<\/li>\n<\/ul>\n<\/li>\n
- But as bond<\/a> yields approach zero during the good times, they don\u2019t have far to fall in a crash.\n
\n- And so they have a limited ability to protect you.<\/li>\n<\/ul>\n<\/li>\n
- And with bond<\/a> yields close to rates on savings accounts, there\u2019s little incentive for private investors to hold bonds at all.<\/li>\n<\/ol>\n
Alternative assets<\/span><\/h6>\nMore diversified portfolios are more stable under inflation, so the obvious fix is to replace some or all of your bonds with alternative assets:<\/p>\n
\n- The obvious candidates are gold and cash.\n
\n- Index-linked bonds don\u2019t protect against inflation (it\u2019s in the price) but rather against higher-than-expected inflation (which is harder to predict).<\/li>\n<\/ul>\n<\/li>\n
- More adventurous investors might consider:\n
\n- other precious metals and commodities in general (particularly oil)<\/li>\n
- private equity and venture capital<\/li>\n
- hedge funds (global macro and long\/short equity \u2013 the latter is not readily available to DIY investors)<\/li>\n
- multi-asset<\/a> investment trusts from the the AIC flexible investment sector \u2013 Ruffer, Caledonia, Personal Assets, Third Point, Capital Gearing<\/a>, RIT and Hansa are familiar names here<\/li>\n
- infrastructure funds and royalty companies<\/li>\n
- and even a small allocation to crypto (particularly in combination with gold)<\/li>\n<\/ul>\n<\/li>\n
- Even more esoteric alternatives include:\n
\n- managed futures\/trend-following (or CTA funds in the US)<\/li>\n
- factor funds (smart beta) and particularly multi-factor market-neutral funds (providing exposure to value, size, momentum<\/a>, low volatility, and quality)<\/li>\n
- patience and diversification are required since no single factor works all the time and many factors have underperformed for years (eg. value right now)<\/li>\n
- long volatility -often a simple combination of the JPY\/AUD FX rate and gold (both safe-haven instruments).<\/li>\n
- tactical asset<\/a> allocation (TAA)<\/li>\n
- options strategies<\/li>\n<\/ul>\n<\/li>\n
- Real assets \u2013 like property, art and farmland \u2013 are another way to go.\n
\n- but most investors in the UK have too much property exposure through their home (since prices are high)<\/li>\n
- the other two assets are difficult and expensive to access.<\/li>\n<\/ul>\n<\/li>\n
- Older investors, in particular, might also have DB<\/a> pensions, which act as an inescapable bond<\/a> portfolio without you choosing to own bonds.<\/li>\n<\/ol>\n
Points of interest<\/span><\/h6>\nOver my four posts, we looked at seventeen articles on fixing 60-40 \/ dealing with inflation.\u00a0Interesting points included:<\/p>\n
\n- Stock returns are inversely related to starting valuations (eg. PEs), which are currently high\n
\n- Stocks prefer falling inflation to rising inflation<\/li>\n
- Inflation higher than 5% pa is bad for stocks, though returns don\u2019t turn negative overall (but you need to ride out some drawdowns)<\/li>\n
- Small size does particularly badly with inflation<\/li>\n
- The worst-affected sectors (particularly under very high inflation) are those that deal directly with consumers (consumer goods, autos, retail) \u2013 they are free to increase their prices but struggle to pass the impact of inflation on to their customers.<\/li>\n
- The best-performing sectors are energy and materials, though traditional energy might become less important to the global economy in the future.<\/li>\n<\/ul>\n<\/li>\n
- Bond<\/a> returns are driven by the coupon (yield) \u2013 these were low at the time, but are now closer to normal\n
\n- More esoteric bonds offer higher yields, but also higher correlations with equities<\/li>\n
- Bonds can be diversifying even with (modest) rising inflation, but as their yields rise, they will lower portfolio returns, so the portfolio is not protected<\/li>\n<\/ul>\n<\/li>\n
- Commodities and gold have close to zero correlation to stocks, but correlations are slightly positive when inflation is rising\n
\n- They also have decent inflationary returns, particularly in rising inflation.<\/li>\n
- Energy stocks also do well, though not as well as the commodities themselves.<\/li>\n
- Note that commodities trend flat over the long-term<\/li>\n
- \u201cA bet on commodities is like a bet against human progress\u201d \u2013 Nicolas Rabener<\/li>\n<\/ul>\n<\/li>\n
- Real estate, PE<\/a> and infrastructure are not true diversifiers \u2013 they depend on positive economic growth (like stocks).\n
\n- The diversification effects they show on paper are flattered by smoothed and lagged valuations.<\/li>\n<\/ul>\n<\/li>\n
- Managed futures and long vol generate similar returns to bonds (with higher volatility)\n
\n- Multi-factor market-neutral generates a lower return than bonds with lower volatility.<\/li>\n
- Managed futures and multi-factor have zero correlation with stocks<\/li>\n<\/ul>\n<\/li>\n
- Long vol has a negative correlation\n
\n- Replacing bonds in a 60\/40 with long vol works well \u2013 the new portfolio has a higher return, lower volatility and lower maximum drawdown.<\/li>\n
- Replacing bonds with long vol, trend and multi-factor also beats the traditional 60\/40, though only slightly.<\/li>\n<\/ul>\n<\/li>\n
- TAA works\n
\n- Gold is the best alternative to stocks, but this leads to larger drawdowns<\/li>\n
- Shorting the S&P 500, and switching to\u00a010-year Treasuries also work, but switching to energy stocks doesn\u2019t protect against inflation (though it works generally)<\/li>\n<\/ul>\n<\/li>\n<\/ol>\n
Original MAN inflation paper<\/span><\/h6>\nThe Best Strategies for Inflationary Times said:<\/p>\n
\n Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect.\u00a0<\/span>Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. <\/span><\/p>\nTrend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability.<\/span><\/p>\n<\/blockquote>\nThe best factor strategies were quality and momentum<\/a>.\u00a0Verdad commented on these findings:<\/p>\n\nHarvey et al. find that trend and quality have been top performing strategies in inflationary regimes historically, as trend would have pushed investors out of stocks at the start of their drawdowns while high quality companies tend to be more resilient in bad times.<\/span><\/p>\n<\/blockquote>\nMan also looked at crypto, concluding that bitcoin is a speculative asset<\/a> with a positive beta to the US stock market \u2013 which makes bitcoin a poor inflation hedge.<\/p>\nThe new paper<\/span><\/h5>\n![\"Henry](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2021\/12\/Henry-Neville-257x300.jpg\")
<\/a><\/p>\nThe new paper is written by Henry Neville, one of the authors of the original MAN paper.<\/p>\n
\n- It looks at seven regime dimensions and tracks how six assets and strategies (Equities, Bonds, Commodities, Long-Short Value, L\/S Momentum<\/a> and Trend) perform through the states within these dimensions.<\/li>\n<\/ul>\n
Inflation<\/span><\/h6>\nThe original paper looked at:<\/p>\n
\nHistoric episodes of general price growth acceleration as those where year-on-year (YoY) inflation rose through 2%, then 5%, then peaked (a state we labelled FIRE).\u00a0<\/span><\/p>\n<\/blockquote>\nThe team has since added three other regimes:<\/p>\n
\nDISINFLATION (high and falling inflation), ICE (low and falling) and REFLATION (low and rising).<\/span><\/p>\n<\/blockquote>\n![\"Inflation](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Inflation-regimes-7-Circles-300x134.jpg\")
<\/a><\/p>\n\nThe top half of the table shows real annualised return (strength of state signal), the bottom shows hit rate (persistence of signal \u2013 red or green cells denote those where performance is consistently positive or negative, defined as in more than 75% of episodes).<\/span><\/p>\n<\/blockquote>\n![\"Inflation](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Inflation-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nReal GDP Growth<\/span><\/h6>\n![\"Real](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Real-GDP-growth-7-Circles-300x134.jpg\")
<\/a><\/p>\n\nWe take the National Bureau of Economic Research (NBER) defined recessions as a baseline. We use the same percentage thresholds as we did for inflation to define the other three episodes. BOOM is high and rising growth, SLUMP is high and falling, RECOVERY is low and rising.<\/span><\/p>\n<\/blockquote>\n![\"Growth](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Growth-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nYield curve<\/span><\/h6>\n![\"10Y](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/10Y-minus-3M-7-Circles-300x134.jpg\")
<\/a><\/p>\n\nWe split the history of the 10Y-3M curve according to a 2\u00d72 matrix: whether the curve in general is rising or falling (bear and bull, respectively), and whether its gradient is steepening or flattening. Given the interest<\/a> in the inverted curve, we add this as a fifth regime state.<\/span><\/p>\n<\/blockquote>\n![\"\"](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Yield-curve-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nStock market<\/span><\/h6>\n![\"Stock](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Stock-market-7-Circles-300x135.jpg\")
<\/a><\/p>\n![\"Stock](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Stock-market-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nInterest rates<\/span><\/h6>\n![\"Interest](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Interest-rates-7-Circles-300x135.jpg\")
<\/a><\/p>\n![\"\"](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Interest-rate-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nCommodity curve<\/span><\/h6>\n![\"Commodity](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Commodity-curve-7-Circles-300x135.jpg\")
<\/a><\/p>\n\nAQR has defined whether the futures curve in aggregate is in backwardation or contango. We\u2019ve taken this data [and] subsumed any episode where the contango or backwardation was shorter than six months within the prior state.<\/span><\/p>\n<\/blockquote>\n![\"Commodity](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Commodity-curve-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nValue vs Growth<\/span><\/h6>\n![\"Value](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Value-vs-growth-7-Circles-300x135.jpg\")
<\/a><\/p>\n\n[The chart] shows the long-term performance of the Fama-French HML factor (as a proxy for a strategy that buys cheap and sells expensive stocks), with time split into Value (yellow) and Growth (blue) states.<\/span><\/p>\n<\/blockquote>\n![\"Value](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/02\/Value-vs-growth-stats-7-Circles-300x224.jpg\")
<\/a><\/p>\nConclusions<\/span><\/h5>\nHenry makes eleven points (though he claims there are only nine):<\/p>\n
\n\n- Inflation is probably the most predictable of the regime frameworks.<\/span>\n
\n- If you are only allowed to use one economic datapoint to guide your decisions, US headline CPI should be it.<\/span><\/li>\n<\/ul>\n<\/li>\n
- There has not been a real growth boom since the 1990s. Fingers crossed for the AI productivity miracle.<\/span><\/li>\n
- Value is consistently one of the hardest investment strategies to fit into a regime framework. <\/span>\n
\n- It is a myth, for example, that it consistently benefits from high and rising inflation. <\/span><\/li>\n
- Don\u2019t touch it when the yield curve is bull flattening.<\/span><\/li>\n<\/ul>\n<\/li>\n
- Equity bull markets are 80% of history.<\/span><\/li>\n
- Bonds are positive (in real terms) in little more than half of equity bear markets. <\/span>\n
\n- Historically there have been better defensive diversifiers.<\/span><\/li>\n<\/ul>\n<\/li>\n
- Equities have ALMOST ALWAYS worked when real growth is booming and when monetary policy is being loosened. <\/span><\/li>\n
- Trend has ALMOST ALWAYS worked when Value is in the ascendant.<\/span><\/li>\n
- Trend and Commodities have ALWAYS worked in states of high and rising inflation.<\/span><\/li>\n
- Bonds have ALWAYS worked in deflationary environments, as well as when monetary policy is being loosened.<\/span><\/li>\n
- Momentum<\/a> has historically done 10% real in states where Value is underperforming, versus 1% in the opposite. <\/span><\/li>\n
- In almost all frameworks, Momentum<\/a> and Trend are positive more than half the time in all states.<\/span>\n
\n- If you can hold through initial reversals, patterns often reassert.<\/span><\/li>\n<\/ul>\n<\/li>\n<\/ol>\n<\/blockquote>\n
That\u2019s it for today.<\/p>\n
\n- It\u2019s been a nice refresher for me on defensive portfolio construction and has encouraged me to further investigate market timing (regime) approaches.<\/li>\n<\/ul>\n
Henry says:<\/p>\n
\nThis is somewhat experimental, scratching an itch that has been nagging me a while. These are my first thoughts, hopefully a conversation starter, do get in touch if you\u2019d like to continue it.<\/span><\/p>\n<\/blockquote>\nLet\u2019s hope that people do.<\/p>\n
It\u2019s a follow-up to a 2021 MAN paper called \u201cThe Best Strategies for Inflationary Times\u201d.<\/p>\n
- \n
- I covered this as part of a series of articles I published that year on whether the traditional 60-40 stock\/bond<\/a> portfolio needed updating in the light of looming inflation.<\/li>\n<\/ul>\n
So before we look at the new paper, I\u2019ll recap what we learned in that series.<\/p>\n
Recap<\/span><\/h5>\n
First, the basics:<\/p>\n
- \n
- Stocks are riskier (more volatile in price) than bonds but have higher long-term returns.<\/li>\n
- The logic of blending two assets together comes from the idea that their prices will move in different directions.\n
- \n
- When stocks go down, you hope that bonds will move up in price.<\/li>\n<\/ul>\n<\/li>\n
- The riskiest portfolio normally recommended by financial advisors to customers with differing levels of risk appetite would be 80-20 stocks\/bonds \u2013 and the safest would be 40-60\n
- \n
- So the 60-40 portfolio can be thought of as the middle option of three.<\/li>\n<\/ul>\n<\/li>\n
- Bonds are a pretty bad hedge for stocks in any case, unless you either hold a lot of them (bad for overall returns) or use a lot of leverage<\/a> (potentially risky, and not easy for private investors).\n
- \n
- However, the 60:40 portfolio is easy to understand and has proved pretty easy to market to investors.<\/li>\n
- It\u2019s also done pretty well over the decades, so many investors would miss it.<\/li>\n
- It was a decent choice following the 2008 crisis until the wheels came off in 2022.<\/li>\n<\/ul>\n<\/li>\n<\/ol>\n
The impact of inflation<\/span><\/h6>\n
- \n
- If inflation rises for an extended period, this could be bad for both stocks and bonds.\n
- \n
- In quant speak, the bond<\/a>-equity correlation might turn positive (it did).<\/li>\n<\/ul>\n<\/li>\n
- This is actually the normal relationship, but in recent years, investors have become used to bonds rising when stocks fall.\n
- \n
- In particular, recession-driven stock market crashes lead to a demand for safe-haven assets, which are traditionally government bonds.<\/li>\n
- So the price goes up, and the yield goes down.<\/li>\n
- When the economy recovers, so do stocks, but bond<\/a> prices fall back.<\/li>\n<\/ul>\n<\/li>\n
- But as bond<\/a> yields approach zero during the good times, they don\u2019t have far to fall in a crash.\n
- \n
- And so they have a limited ability to protect you.<\/li>\n<\/ul>\n<\/li>\n
- And with bond<\/a> yields close to rates on savings accounts, there\u2019s little incentive for private investors to hold bonds at all.<\/li>\n<\/ol>\n
Alternative assets<\/span><\/h6>\n
More diversified portfolios are more stable under inflation, so the obvious fix is to replace some or all of your bonds with alternative assets:<\/p>\n
- \n
- The obvious candidates are gold and cash.\n
- \n
- Index-linked bonds don\u2019t protect against inflation (it\u2019s in the price) but rather against higher-than-expected inflation (which is harder to predict).<\/li>\n<\/ul>\n<\/li>\n
- More adventurous investors might consider:\n
- \n
- other precious metals and commodities in general (particularly oil)<\/li>\n
- private equity and venture capital<\/li>\n
- hedge funds (global macro and long\/short equity \u2013 the latter is not readily available to DIY investors)<\/li>\n
- multi-asset<\/a> investment trusts from the the AIC flexible investment sector \u2013 Ruffer, Caledonia, Personal Assets, Third Point, Capital Gearing<\/a>, RIT and Hansa are familiar names here<\/li>\n
- infrastructure funds and royalty companies<\/li>\n
- and even a small allocation to crypto (particularly in combination with gold)<\/li>\n<\/ul>\n<\/li>\n
- Even more esoteric alternatives include:\n
- \n
- managed futures\/trend-following (or CTA funds in the US)<\/li>\n
- factor funds (smart beta) and particularly multi-factor market-neutral funds (providing exposure to value, size, momentum<\/a>, low volatility, and quality)<\/li>\n
- patience and diversification are required since no single factor works all the time and many factors have underperformed for years (eg. value right now)<\/li>\n
- long volatility -often a simple combination of the JPY\/AUD FX rate and gold (both safe-haven instruments).<\/li>\n
- tactical asset<\/a> allocation (TAA)<\/li>\n
- options strategies<\/li>\n<\/ul>\n<\/li>\n
- Real assets \u2013 like property, art and farmland \u2013 are another way to go.\n
- \n
- but most investors in the UK have too much property exposure through their home (since prices are high)<\/li>\n
- the other two assets are difficult and expensive to access.<\/li>\n<\/ul>\n<\/li>\n
- Older investors, in particular, might also have DB<\/a> pensions, which act as an inescapable bond<\/a> portfolio without you choosing to own bonds.<\/li>\n<\/ol>\n
Points of interest<\/span><\/h6>\n
Over my four posts, we looked at seventeen articles on fixing 60-40 \/ dealing with inflation.\u00a0Interesting points included:<\/p>\n
- \n
- Stock returns are inversely related to starting valuations (eg. PEs), which are currently high\n
- \n
- Stocks prefer falling inflation to rising inflation<\/li>\n
- Inflation higher than 5% pa is bad for stocks, though returns don\u2019t turn negative overall (but you need to ride out some drawdowns)<\/li>\n
- Small size does particularly badly with inflation<\/li>\n
- The worst-affected sectors (particularly under very high inflation) are those that deal directly with consumers (consumer goods, autos, retail) \u2013 they are free to increase their prices but struggle to pass the impact of inflation on to their customers.<\/li>\n
- The best-performing sectors are energy and materials, though traditional energy might become less important to the global economy in the future.<\/li>\n<\/ul>\n<\/li>\n
- Bond<\/a> returns are driven by the coupon (yield) \u2013 these were low at the time, but are now closer to normal\n
- \n
- More esoteric bonds offer higher yields, but also higher correlations with equities<\/li>\n
- Bonds can be diversifying even with (modest) rising inflation, but as their yields rise, they will lower portfolio returns, so the portfolio is not protected<\/li>\n<\/ul>\n<\/li>\n
- Commodities and gold have close to zero correlation to stocks, but correlations are slightly positive when inflation is rising\n
- \n
- They also have decent inflationary returns, particularly in rising inflation.<\/li>\n
- Energy stocks also do well, though not as well as the commodities themselves.<\/li>\n
- Note that commodities trend flat over the long-term<\/li>\n
- \u201cA bet on commodities is like a bet against human progress\u201d \u2013 Nicolas Rabener<\/li>\n<\/ul>\n<\/li>\n
- Real estate, PE<\/a> and infrastructure are not true diversifiers \u2013 they depend on positive economic growth (like stocks).\n
- \n
- The diversification effects they show on paper are flattered by smoothed and lagged valuations.<\/li>\n<\/ul>\n<\/li>\n
- Managed futures and long vol generate similar returns to bonds (with higher volatility)\n
- \n
- Multi-factor market-neutral generates a lower return than bonds with lower volatility.<\/li>\n
- Managed futures and multi-factor have zero correlation with stocks<\/li>\n<\/ul>\n<\/li>\n
- Long vol has a negative correlation\n
- \n
- Replacing bonds in a 60\/40 with long vol works well \u2013 the new portfolio has a higher return, lower volatility and lower maximum drawdown.<\/li>\n
- Replacing bonds with long vol, trend and multi-factor also beats the traditional 60\/40, though only slightly.<\/li>\n<\/ul>\n<\/li>\n
- TAA works\n
- \n
- Gold is the best alternative to stocks, but this leads to larger drawdowns<\/li>\n
- Shorting the S&P 500, and switching to\u00a010-year Treasuries also work, but switching to energy stocks doesn\u2019t protect against inflation (though it works generally)<\/li>\n<\/ul>\n<\/li>\n<\/ol>\n
Original MAN inflation paper<\/span><\/h6>\n
The Best Strategies for Inflationary Times said:<\/p>\n
\n
Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect.\u00a0<\/span>Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. <\/span><\/p>\n
Trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability.<\/span><\/p>\n<\/blockquote>\n
The best factor strategies were quality and momentum<\/a>.\u00a0Verdad commented on these findings:<\/p>\n
\n
Harvey et al. find that trend and quality have been top performing strategies in inflationary regimes historically, as trend would have pushed investors out of stocks at the start of their drawdowns while high quality companies tend to be more resilient in bad times.<\/span><\/p>\n<\/blockquote>\n
Man also looked at crypto, concluding that bitcoin is a speculative asset<\/a> with a positive beta to the US stock market \u2013 which makes bitcoin a poor inflation hedge.<\/p>\n
The new paper<\/span><\/h5>\n
<\/a><\/p>\nThe new paper is written by Henry Neville, one of the authors of the original MAN paper.<\/p>\n
- \n
- It looks at seven regime dimensions and tracks how six assets and strategies (Equities, Bonds, Commodities, Long-Short Value, L\/S Momentum<\/a> and Trend) perform through the states within these dimensions.<\/li>\n<\/ul>\n
Inflation<\/span><\/h6>\n
The original paper looked at:<\/p>\n
\n
Historic episodes of general price growth acceleration as those where year-on-year (YoY) inflation rose through 2%, then 5%, then peaked (a state we labelled FIRE).\u00a0<\/span><\/p>\n<\/blockquote>\n
The team has since added three other regimes:<\/p>\n
\n
DISINFLATION (high and falling inflation), ICE (low and falling) and REFLATION (low and rising).<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\n\n
The top half of the table shows real annualised return (strength of state signal), the bottom shows hit rate (persistence of signal \u2013 red or green cells denote those where performance is consistently positive or negative, defined as in more than 75% of episodes).<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\nReal GDP Growth<\/span><\/h6>\n
<\/a><\/p>\n\n
We take the National Bureau of Economic Research (NBER) defined recessions as a baseline. We use the same percentage thresholds as we did for inflation to define the other three episodes. BOOM is high and rising growth, SLUMP is high and falling, RECOVERY is low and rising.<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\nYield curve<\/span><\/h6>\n
<\/a><\/p>\n\n
We split the history of the 10Y-3M curve according to a 2\u00d72 matrix: whether the curve in general is rising or falling (bear and bull, respectively), and whether its gradient is steepening or flattening. Given the interest<\/a> in the inverted curve, we add this as a fifth regime state.<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\nStock market<\/span><\/h6>\n
<\/a><\/p>\n<\/a><\/p>\nInterest rates<\/span><\/h6>\n
<\/a><\/p>\n<\/a><\/p>\nCommodity curve<\/span><\/h6>\n
<\/a><\/p>\n\n
AQR has defined whether the futures curve in aggregate is in backwardation or contango. We\u2019ve taken this data [and] subsumed any episode where the contango or backwardation was shorter than six months within the prior state.<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\nValue vs Growth<\/span><\/h6>\n
<\/a><\/p>\n\n
[The chart] shows the long-term performance of the Fama-French HML factor (as a proxy for a strategy that buys cheap and sells expensive stocks), with time split into Value (yellow) and Growth (blue) states.<\/span><\/p>\n<\/blockquote>\n
<\/a><\/p>\nConclusions<\/span><\/h5>\n
Henry makes eleven points (though he claims there are only nine):<\/p>\n
\n
- \n
- Inflation is probably the most predictable of the regime frameworks.<\/span>\n
- \n
- If you are only allowed to use one economic datapoint to guide your decisions, US headline CPI should be it.<\/span><\/li>\n<\/ul>\n<\/li>\n
- There has not been a real growth boom since the 1990s. Fingers crossed for the AI productivity miracle.<\/span><\/li>\n
- Value is consistently one of the hardest investment strategies to fit into a regime framework. <\/span>\n
- \n
- It is a myth, for example, that it consistently benefits from high and rising inflation. <\/span><\/li>\n
- Don\u2019t touch it when the yield curve is bull flattening.<\/span><\/li>\n<\/ul>\n<\/li>\n
- Equity bull markets are 80% of history.<\/span><\/li>\n
- Bonds are positive (in real terms) in little more than half of equity bear markets. <\/span>\n
- \n
- Historically there have been better defensive diversifiers.<\/span><\/li>\n<\/ul>\n<\/li>\n
- Equities have ALMOST ALWAYS worked when real growth is booming and when monetary policy is being loosened. <\/span><\/li>\n
- Trend has ALMOST ALWAYS worked when Value is in the ascendant.<\/span><\/li>\n
- Trend and Commodities have ALWAYS worked in states of high and rising inflation.<\/span><\/li>\n
- Bonds have ALWAYS worked in deflationary environments, as well as when monetary policy is being loosened.<\/span><\/li>\n
- Momentum<\/a> has historically done 10% real in states where Value is underperforming, versus 1% in the opposite. <\/span><\/li>\n
- In almost all frameworks, Momentum<\/a> and Trend are positive more than half the time in all states.<\/span>\n
- \n
- If you can hold through initial reversals, patterns often reassert.<\/span><\/li>\n<\/ul>\n<\/li>\n<\/ol>\n<\/blockquote>\n
That\u2019s it for today.<\/p>\n
- \n
- It\u2019s been a nice refresher for me on defensive portfolio construction and has encouraged me to further investigate market timing (regime) approaches.<\/li>\n<\/ul>\n
Henry says:<\/p>\n
\n
This is somewhat experimental, scratching an itch that has been nagging me a while. These are my first thoughts, hopefully a conversation starter, do get in touch if you\u2019d like to continue it.<\/span><\/p>\n<\/blockquote>\n
Let\u2019s hope that people do.<\/p>\n
- It\u2019s been a nice refresher for me on defensive portfolio construction and has encouraged me to further investigate market timing (regime) approaches.<\/li>\n<\/ul>\n
- Equities have ALMOST ALWAYS worked when real growth is booming and when monetary policy is being loosened. <\/span><\/li>\n
- Don\u2019t touch it when the yield curve is bull flattening.<\/span><\/li>\n<\/ul>\n<\/li>\n
- There has not been a real growth boom since the 1990s. Fingers crossed for the AI productivity miracle.<\/span><\/li>\n
- If you are only allowed to use one economic datapoint to guide your decisions, US headline CPI should be it.<\/span><\/li>\n<\/ul>\n<\/li>\n
- Inflation is probably the most predictable of the regime frameworks.<\/span>\n
- It looks at seven regime dimensions and tracks how six assets and strategies (Equities, Bonds, Commodities, Long-Short Value, L\/S Momentum<\/a> and Trend) perform through the states within these dimensions.<\/li>\n<\/ul>\n
- Stock returns are inversely related to starting valuations (eg. PEs), which are currently high\n
- The obvious candidates are gold and cash.\n
- But as bond<\/a> yields approach zero during the good times, they don\u2019t have far to fall in a crash.\n
- This is actually the normal relationship, but in recent years, investors have become used to bonds rising when stocks fall.\n
- In quant speak, the bond<\/a>-equity correlation might turn positive (it did).<\/li>\n<\/ul>\n<\/li>\n
- If inflation rises for an extended period, this could be bad for both stocks and bonds.\n
![](\"https:\/\/the7circles.uk\/wp-content\/uploads\/2024\/03\/Author-pic-fix-150x150.jpg\")
<\/div>\n