Knowing the inflation and growth regime is critical for equity and bond investing

 

Picking stocks and bonds is a critical part of investing, yet make no mistake, the inflation and growth environment do matter. It is critical to know what is the macro regime. Now it is hard to say what is the current regime relative to past history since you are living in the current; nevertheless, if you can formulate a view on the current regime, you can provide meaningful policy tilts for the benefit of your overall portfolio. When inflation is high, avoid bonds. When growth is high, hold stocks. This does not have to be complex, but a regime view is critical. 

The dampened business cycle - Will this continue?

 

We present two charts: one showing the dampened business cycle and the second on current growth forecasts. First, we are in abnormal period based on the low percentage of the time in recession. The data clearly shows that the business cycle has been dampened, yet the post-GFC period has been extremely mild. The question is whether this is the new normal. Have we eliminated economic downside? That conclusion is unlikely which leads to our second chart.

The Atlanta Fed GDPNow forecast is showing a significant decline in growth for the first quarter. Interest rates are higher. The projected growth expectations have been lower albeit the Blue Chip consensus is still at 2+ percent. Nevertheless, policy and trade uncertainty are causing many businesses to turn conservative. The GDPNow estimates provide a strong warning sign that if current trends continue, we will have a recession sooner than when most think. 

The value of overnight trading

One of the more interesting anomalies is what we can call the overnight effect - the fact that most of the returns generated for the many stocks and indices occur between the close and open and not during normal trading hours between the open and close. This may seem obvious to many given that much of the important news about stocks is generated after the close and before the open. For example, most earnings announcements are made when the market is closed. Chart is from Elm Street. 

However, some have argued that this is a result of price manipulation, see Bruce Knuteson, who suggests that price pressure overnight leads to then declines during the day. This manipulation focuses on pushing prices higher during less liquid times and then offsetting the gains during the day. This is an interesting and compelling story and is consistent with the data; however, it is not clear who and how big is this activity. 

Surprisingly there has not been much research explaining this anomaly other than to document its existence. 

Sector size and equity bubbles

 

The FT provided an interesting bubble chart on the size of the IT sector relative to the US markets and the rest of the world. Of course, we have been following the size of the Mag 7 relative to the rest of the SPY over the last year, but the size of the IT sector versus the rest of the world is crazy and suggests that the market is overvalued and in a bubble. Just look at the difference in size for the IT sector between 2010 and 2025 with the rest of the world.

There we go again with that term - bubble. The term is thrown around yet saying that a market or stock is in a bubble does not provide any action plan for what to do. The IT is larger, but what is the appropriate size? IT is clearly more important to the world economy today than in 2010, yet should it be larger than the market cap of the UK, Japan, and China combined? IT is changing the world, but how should this be valued as discounted future cash flows. 

One can avoid these markets and stocks but there is a strong opportunity cost. You will miss the sizable move and be out of balance with a market weighted portfolio. If you are a passive index holder, you are riding the bubble, so if you want to avoid, you will have to drop these market-weighted indices. Shorting is an alternative, but the pain until a crash is high and no one knows when a crash will occur. So, is it just a game of watching? 

Market efficiency and financial crises

 

An older paper has come across my desk as a good review of the history of the efficient markets hypothesis (EMH) as well as   a novel view about how the EMH fit within a world with pricing bubbles, see Stephen Brown in the "The Efficient Markets Hypothesis: the Demise of the Demon of Choice".

Brown provides a good explanation of the foundations in the EMH along with the fact that most practitioners do not believe in the efficient markets hypothesis. Nevertheless, even though the EMH may. to be true, it may be important for many to believe that it is close to truth. Many will lose money attempting to prove the EMH to be false. Because there is this lack of belief in the EMH, many traders will take more risk and use more leverage than they should. Of course, when a crisis comes there will be greater loses and many traders are on the wrong side of the market.

NYFed MCT suggests further persistence

The NYFed developed the multivariate Core Trend (MCT) model for PCE inflation to look at the persistence or trend of inflation components in the PCE. It tracks the PCE closely and explains why the Fed believed that inflation would not be persistent during 2022. The MCT numbers did not suggest that the components would persist. The PCE moved back to the longer-term MCT, yet the current data tells a story that the Fed is not winning the war on inflation. Inflation seems to be stuck just below the 3% level. By this measure, we are unlikely to see the Fed come close to the 2% target.  

Follow the liberal arts to be a good analyst

Debate logic with your acquaintances, And practice rhetoric in your common talk; Use music and poetry to quicken your mind; Turn to mathematics and metaphysics when you can stomach it. 

- TheTaming of the the Shrew 

To be a good analyst you need more than just math and quant skills. You also need more that finance knowledge. You need to have a complete set of skills that mixes logic, rhetoric, and math. All have to be practiced on a regular basis to be part of your everyday thinking. 

Recorde on needing numbers

 If number be lacking 

It maketh men dumb

So that to most questions 

They must answer mum 

The Ground of Arts - Robert Recorde

Recorde invented the equal sign in the mid-16th century and was an important English mathematician. I like this quote because ti presupposes that you need to have numbers to answer most questions. He would have made a good quant today. 

The markets have gotten defensive

Volatility is on the rise with the VIX strongly moving above three-month averages except for the Fed announcement spike in December. This is the first full month of the new Trump presidency, and the uncertainty has resulted in risk-taking caution. 

The overall stock market was down 1.3% (SPX), but small caps declined by 5.7%. The Treasury bond index posted a gain of 1.54%. What was most important was the differential between low volatility (4.67%) and high beta stocks (-4.89%). Similarly, there was a strong difference between consumer stables (5.70%) and consumer discretionary (-9.37%). 

All this suggests that the markets are discounted uncertainty and likely slowdown in economic growth. There is less euphoria and more of a belief that we are in a position of market change.