Perhaps it is not stupidity, but the connections between market indicators tell us something about a regime and we have a high degree of similarity across market indicators we are receiving a signal of a regime. The simplest regime is the business cycle or more specifically, a recession. A market downturn changes everything and is our key systematic risk which requires a risk premium. There has been significant work to refine different regimes based on volatility, policy choices, and market environment with different levels of success. What is found that whether asset class or factors, there different asset or risk factors will behave differently based on the regime. If an investor can predict correctly, the regime, he can rotate portfolio allocations and improve overall return.
A new paper has been added to the regime research, "Regimes". It uses a simple methodology for defining regimes and then trying to exploit the relationship. The authors look at a set of macro variables that have different correlation. They transform the data into z-scores and then use a distance function to form a similarity metric. This similarity measure can be used as the basis for making portfolio decisions. This works because the z-scores of the economic variables have a persistence. If we can find periods of similarity between current values and the past and then look at the returns associated with that period, we can then make a judgement on what may happen next period.
The interesting part of this work is that it is consistent with how investors think about the market. We look at events today and then search for similar event periods in the past and then extrapolate what may happen in the future. This is done on an ad hoc basis but using a similarity score it can be quantified.
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