Risk-on in US but not for the rest of the world

Call it the pain of international diversification for 2018. With a significant divergence between US and international equities, the cost with holding DM and EM stocks has been significant. The differential between EM and US growth indices is over 25%.  August just added to this different with fears of sudden stops in risky EM countries. Turkey and Argentina have both showed that credit flows can change quickly in a sensitive macro environment.

The sector analysis shows continued strength in technology, health and consumer discretionary sectors. The health and technology gains are theme-rated while consumer discretionary pinpoints the strong economic growth of 2018. All sectors point to further gains except for the energy sector.

Sovereign country ETFs show the global fears gripping equity investors. Weaker macro environments saw continued sell-off in August. Investors are taking a closer look at leverage and underlying economic structures in EM markets.

Bond market performance was generally consistent with a strong risk-on investment environment for 2018, but Treasuries gained in August based on global flight to quality. International and EM bonds showed continued weakness based on the strong dollar.

Trend and breakout analysis suggests a long focus on US style ETF's and continued avoidance of DM and EM equity investments. Sector bets focus on economic growth and technology. Avoid risky sovereigns and accept that while bonds may do better on flight to quality, they will reflect the strong risk-on US environment.

Gold - The asset we often use to project fear and optimism

Gold is hard to understand as an investment. Sometimes it behaves like an inflation hedge but at other times it does not. Sometimes it responds to the real cost of funds, and sometime it does not. It can serve as a safe asset, yet it has sold-off in a crisis. It can be the uncorrelated asset of frustration, but a longer examination tells us about investment deep investor expectations. Gold, over the last decade, can be viewed through three major themes.

1. The debasement fears period  - This was the period of maximum gain in quantitative easing. This period ends with QE2 and when QE policy seemed to be a limited accelerant to the real economy.

2. The adjustment to QE period - Contrary to many analysts the exposure of the Fed balance sheet did not led to a surge in inflation. In fact, large central bank balance sheets did not even allow inflation to get to target levels. Even with negative rates on trillions in bonds, investors did not view gold as essential if there was not going to be a debasement of nominal assets. 

3. The "who cares about debasement" or "new normal" period  - The third period began with the tapering and moved to the new period of Fed adjustment with increasing rates. Inflation is closer to target, but the expectation of a monetary debasement of bonds has left investors to be replace by a sense of complacency or normalcy. Investors have found a new equilibrium where they believe central banks will not drive the economy to the monetary brink. Balance sheet holdings will be higher than pre-crisis levels, but the potential for a significant inflation overshoot is minimal. Financial assets have exploded to the upside, but gold has still doubled since 2007 levels. 

The question is whether there will be a new fourth period for gold and what will it look like. We may not know what this new gold environment will look like until central banks are forced to again change policy.

The Two Disconnects of 2018 - Market Behavior Versus Politics and US Versus International

What can be called the twin disconnects of 2018 have continued this summer. There is the disconnect between market and political behavior. If you read the newspaper headlines, you would think there is government confidence crisis in the US, yet  if you plot market activity, any investor would suggest the economy is in great shape. There is also the disconnect between US market activity and global market behavior. 2018 is shaping up to be a great year especially for small cap and growth benchmarks that are both up double digits with August again showing strong performance. Global and emerging markets, both equities and bonds, are sickly. 

Disconnect of this magnitude do not last and as we come back from summer vacation and focus on asset allocation, the big issue is to either maintain or fade the major dislocations. Cut US stock exposure and add international equities. Cut risky equities and add to bond exposure. Unfortunately, it will take some major fortitude to make the switch against momentum, current macro data, and firm-specific strength. There is a wall of worry concerning high credit exposure and leverage, but it may still be early to make expensive allocation changes. Still, early after a great 8 months may be a safe strategy.

Judgment And Experience - A Recipe For Success For Any Strategy

Each situation requires a balancing derived from judgment and arising from experience, skills acquired by learning from the past and training for the future. 

Theory reduces history's complexity to teachable moments.... Instead theory functions, with respect to the past, as Clausewitz's coups de'oeil do in the present: it extracts lessons from infinity variety. It sketches, informed by what you need to know, without trying to tell you too much. For in classrooms as on battlefields, you don't have unlimited time to listen. Theory, then, serves practice. And when practice corrects theory - when it removes theorists' horse blinders - it returns the favor, preventing stumbles off cliffs, into swamps, and toward Moscow. 
- John Lewis Gaddis On Grand Strategy discussing Tolstoy and Clausewitz as the grandest strategists

The combination of judgment and experience tied to disciplined systematic thinking in an uncertain world has been a recurring theme in this blog. Systematic and disciplined behavior through models improves the odds for success in a volatile, uncertain, complex, and ambitious (VUCA) environment. Our judgment is gained through theory that does not stand-alone but provides direction for our practice and our discipline. Judgment and experience allows strategy to move beyond abstraction. Strategy is directed by experience and filtered by theory.

For the quantitative-focused manager, theory is needed to form beliefs, but data is needed to set the level of significance and direction in practice. This practice is best served through planning and disciplined. Systematic behavior is not immutable, but can change with new facts. It can change with new situations, but theory, guided by our lessons form the past, serves as a foundation for action.

Gaddis writes about similar issues throughout history in his sweeping book on strategy. Understanding the ends and the limits of our means is critical for success. Failure arises when ends and means are not coordinated and the limitation of means leads to overreach for the ends.

We have discussed Clausewitz in the context of the "fog of trading" as someone who understands the limitations from uncertainty coupled with unclear goals. (See "On the "fog of war" - No one gets this quote right, but the concept stands".)  Strategy clarifies goals and limitation with uncertainty. The failure to find the central theme or objective of strategy will lead to ambiguity in action. (See "What is your focus? Schwerpunkt - The center of gravity for your investment efforts".) The complexity of grappling with means, ends, and process has been expressed in the narrative of the hedgehog and fox though Isiah Berlin's broad commentary on Tolstoy. Different visions will impact strategies. Trying to forecast the future will be affected by whether you are a hedgehog specialized or the broader focused fox. (See "The "Hedgehog and the Fox" revisited - Find managers with big ideas, but diversify".) 

Investor success will be predicated on their ability to exploit technical and practical knowledge, a variation on the theory of rationalism developed by the philosopher, Michael Oakeshott. (See "Technical and practical knowledge - You need both for asset management".) For Gaddis, the combination is judgment and experience which has been shown to be missing in failure and balanced in success. Disciplined investing is a strategy not developed in a vacuum but based on an understanding of market behavior, decision limitations, and manager experience.