Executive Summary for WEALTHSHIELD WHITEPAPER SERIES, ECONOMIC GROWTH
“It’s the economy, stupid” is the often-cloned phrase coined by James Carville, a strategist in President Bill Clinton’s 1992 campaign. Politics aside, this is very true in the investment world. While it might not always seem like it, the markets are the scoreboard for the economy. According to Ray Dalio, the founder of Bridgewater, the largest and most profitable (in dollars) hedge fund, the best predictor of asset class returns are economic growth and inflation. Economic growth and inflation go through periods of acceleration (sometimes simultaneously) and deceleration. The ebb and flow of growth and inflation determine the business cycle. If you get the business cycle right, in our opinion, you get the market cycle right.
Business cycle illustration; source: WealthShield; as of May 2020
The authors of this paper, Clint Sorenson and Luke Vernon dig into the US business cycle to observe economic growth and inflation trends throughout the cycle, use these observations to determine what factors and investment exposures may perform best in each phase, and test a simple system of adapting a portfolio allocation given the observed business cycle.
Their goal is to develop and test a potential investment system, to eventually use in the “real world,” using leading economic or business cycle indicators. A leading economic indicator (LEI) less than zero and accelerating could be identified as in the recovery phase, greater than zero and accelerating could equal an expansion phase, greater than zero and decelerating could mean a slowdown, and less than zero and decelerating means that a contraction is probable. To test an investment system, the authors hypothetically “invested” in a momentum factor when LEI year over year was above zero and “invested” in low volatility equities when LEI was below zero. They hypothesize that allocating according to the business cycle and rotating the factors will outperform the broad market and “buying & holding” factors in isolation. This test was determined to be successful, delivering over 5% per year in return above the broad market, lessened the maximum peak to trough loss (drawdown) by 16%, and provided more positive return years than the benchmark.
We believe this test demonstrates the importance of understanding where we are in the business cycle and making investment decisions based on that information. This has become an important piece of the investment framework for WealthShield and Sound Financial. Mark Twain once said, “history may not repeat itself, but it often rhymes.” Measuring data, gather and researching the facts, and comparing these to past events are some of the keys to investing money wisely. This rules-based approach helps prevent us from letting emotions drive our decision making and we believe puts our clients in a strong position to reach their financial goals.