Regime-based tactical asset allocation - it can add value

A simple paper that focuses on tactical asset allocation based the business cycle suggest that using macro top-down information will be helpful for forming a dynamic portfolio. See "Regime-Based Strategic Asset Allocation". 

The authors break up the macro environment into four regimes: overheating, goldilocks, stagflation, and downturn. Given these environments, different portfolios are formed using just five assets: equities, government bonds, credit, commodities, and REITs. Given these 5 assets, the authors form risk-based and equal-weighted portfolios focused on regime probabilities and compare with an optimized, equal-weighted, and risk budget portfolios. These portfolio constructs suggest that regime-based portfolios can support better risk-adjusted returns.

 

Perhaps macro announcements are not that important

 

Following earlier work on macro announcements effects, there is a paper that states that macroeconomics are associated with approximately half of the equity premium. Now this seems like a large number, but earlier works has argued that 100% of the equity risk premium is associated with selected macroeconomic days and over half the days in the sample may be announcement days. This may be due to sample selection. See "More than 100% of the equity premium: How much is really earned on macroeconomic announcement days?"

When all announcements are included, the Sharpe ratio between announcement and non-announcement days are approximately equal. They conclude that these days are not so special. 

This is a good piece of research, but we do know that some days are more important than others, so a selected sample of special announcement days seems reasonable. If we condition on the size of the announcement, the excess return may be even greater. Nevertheless, this research should temper any investor who thinks he can just buy announcement dates as the road to riches. 

Why focus on macro announcements? That is where all of the return action is

Macro announcements matter and impact returns. If we look at announcement days versus non-announcement days, there is a significant difference in excess returns. This is applicable at all levels of beta.  This work is nicely presented in the paper, "The Macroeconomic Announcement Premium", and shows that this excess return story is applicable for stocks and bonds.

Trade the macro announcements for profit. 

 

What are you playing - the pricing or the valuation game

Aswath Damodaran, the renowned professor of finance at the Stern School at NYU has done a good job of comparing two approaches to looking at asset returns, the pricing game, and the valuation game.

The pricing game is based on the belief that price is the only number that can be acted upon. You don't know the true value of an asset so follow the trend. If prices seem to be moving to an extreme relative to past behavior use that as basis for spread trading. This is the basis for technical trading. 

The value game is based on the belief that an asset can be given a fair value. Find the fair value and use that as the basis to trade. When value is low relative to current prices, buy and when value is high versus prices, sell.

I like this comparison because it is an easy guide to describe the type of traders in the market. Of course, there are hybrids that have the features of both. Similarly, this framework can be used to describe quants and discretionary traders.