The Discovering Markets Hypothesis - Worth a close look to add to our thinking of market dynamics

There are alternative views on how markets operate that are different from the efficient markets hypothesis which has taken a beating since the development in behavioral finance. Andrew Lo came up with the concept of Adaptive markets, but Tom Mayer and Marius Kleinheyer have developed an alternative called the Discovering Markets Hypothesis (DMH) which is based on three key points. Information held or learned by investors should be viewed as subjective not objective knowledge and this knowledge is adjusted when it compared against the behavior of others. Investors will communicate with others to cross-check their subjective knowledge. The communication of knowledge is through narrative. Narratives compete through their influence on prices. 

Facts influence subjective knowledge which is then shared with others through narratives. These narratives compete with others through their influence on prices. Prices, of course, will then provide feedback on the quality of the narrative. As subjective knowledge changes, there will be an impact on prices. Facts or new information will drive the changes in subjective knowledge. Because subjective knowledge cannot be counted or measured with certainty, there will be inherent uncertainty in markets which will cause prices to change in ways that are not always expected. 

The wild card for bond yields - the term premium

 

Treasury yield have moved higher while the Fed has lowered interest rates. This was not supped to happen. The question now is determining what is the fair value for Treasury yield out the curve. The usual method is to determine the real rate of interest which usually is about 2% plus some estimate of expected inflation which can be argued to be at level above 2%. So, if we use a real rate of 2% and an inflation rate of 2.5% we are at 4.5% as a good starting point; however, we need to add a term premium for the risk from holding these bonds out the curve. That number has been negative for an extended period but is now positive and rising. The current term premium is at the highest level in over a year; however, a longer history suggests that it can increase by a multiple of the current levels. One reason could be the lower liquidity in Treasuries, yet the recent fall is not seen in the term premium. Forecasting the term premium is now the Treasury yield forecast will card. 

Trend-following with industry groups - It works

 

In the paper, "A Century of Profitable Industry Trends" the authors explore long-only trend following for a 48 industry portfolio for just under a one hundred year period. They find that the simple trend timing strategy will lead to higher returns, lower volatility, higher Sharpe ratio and less downside risk. This strategy is easy to implement and is shown to work with sector ETFs with a smaller portfolio of 31 industries. The numbers are compelling and again show that a trend strategy can be effective. The strategy is effect with equal weighting, timing and sizing allocations. It may not work during every period, but the long run return beat the simple strategy of holding the market portfolio.

There is no equity risk premium!

There are several ways of measuring the equity risk premium. The above chart is a simple approach, and it shows the premium is at levels not seen since the dot-com bubble. Other approaches may show the premium slightly higher, but all are signaling that we are are at low levels which suggests that forward returns are likely to be lower.  

This is not saying returns will be negative in the next year nor does it say we will have a crash. It is saying that your long-term allocation to stocks is unlikely to generate returns similar to what were present over the post-COVID period.