Having Bought The Dip…

The Fed’s 4Q18 Z1 data is out so I am able to update this little model of prospective 10-year returns for the S&P 500. If we could run this again today I suspect it’d be forecasting about 6-7% for the next 10 years, given how we’ve rallied in 1Q19. Not spectacular but not awful, either. Clearly, in the aggregate we bought the dip.

4Q18_SP_ER
Data Sources: Federal Reserve Z1 Release & Demonetized Calculations

Below is the latest expected returns bar chart from RAFI. Definitely a less optimistic picture for US large cap equities, but I believe this is a (small) improvement over the last time I checked it. The “obvious” relative value play is of course ex-US equity and emerging market equity in particular. I put “obvious” in scare quotes here because there are real risks to tilting a portfolio this way, as I’ll discuss a bit more below.

20190308_RAFI
Source: Research Affiliates

This is merely a brief analytical exercise for perspective. Like all models, these ones have weaknesses. The most significant, in my view, is they’re not “macro aware.” For example, the S&P 500 model above would not have given you any warning of the global financial crisis. Today, as far as the differences in relative valuation between US and ex-US equities are concerned, we live in a time where there is a strong argument to be made that globalization is unraveling. And if globalization truly unravels, the intuition underlying global equity investing unravels along with it.

The two risks I worry most about these days?

Geopolitical fragmentation. Taken to a certain extreme, this would break the idea of a globally diversified equity portfolio.

A major spike in inflation. This would break the traditional 60/40 portfolio, at least in real terms.

These risks don’t just represent asset price volatility. They represent regime changes. They represent changes in the relationships between financial assets–changes in financial gravity. My friend Ben Hunt has written what I think is the best piece about what an inflationary regime change means for investors. The short version is that it’s the death of the long bond as an effective diversifier.

Geopolitical risk is trickier. I’m extremely skeptical anyone can effectively handicap geopolitical risk. It’s not something you predict. It’s something you observe. You deal with it when it manifests in the real world, as it happens. Of course, in theory you can hedge this kind of risk. The folks who sell this protection aren’t usually in the habit of giving it away at firesale prices, though I guess it never hurts to check around. Every once in a while you will find something stupid cheap like VIX calls circa 2017 and early 2018.

There is another factor in play here that I don’t consider so much a “risk” as a “force” that acts on everything else. That is fiscal and monetary policymaking–particularly monetary policymaking. Our friendly neighborhood central bankers have made it overwhelmingly clear they intend to remain supportive of financial markets. This will shape the market regime and therefore the relationships between financial assets. Like geopolitical risk, it’s not something you can effectively handicap. As I’ve written elsewhere:

Fed Watching is the ultimate reflexive sport. If you believe there is some kind of capital-T objective Truth to be found in Fed Watching, I am sorry to be the one to tell you but you are one of the suckers at the table. The Fed knows we all know that everyone knows the information content of Jay Powell’s statements is high. (We call them Fed Days, for god’s sake) The Fed plays the Forward Guidance Game accordingly. Sometimes it uses its “data” and “research.” Sometimes it speaks through one of its other hydra heads. The tools and tactics vary, but they’re all deployed to the same end: to shape the subjective realities of various economic and political actors.

I am critical of the current approach to monetary policymaking both in the United States and abroad. However, I do not think shorting the world or sitting 100% in cash or gold is a particularly good strategy. Two reasons:

  1. If the world ends you are probably not going to have much fun collecting on your bet because it will be the end of the global financial system as we know it. You’re better off investing in guns and ammo and maybe a bunker somewhere to express this view.
  2. You are betting against the combined fiscal and monetary policymaking apparatuses of every country in the world. Kind of like shorting a stock where the CEO has unlimited cash available to buy back stock.

Personally, I’m doing my best to balance cautious optimism with a healthy amount of paranoia.

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