Landon Whaley explains why it is more important to know the fundamental environment for a market and trade accordingly, than to make “calls on the market.”
This week’s Headline Risk comes courtesy of the Old Institution’s predilection towards making “calls” on the market. In his most recent Monday Morning Note, Morgan Stanley’s Mike Wilson warns that the deteriorating market breadth is the "precursor to the first tradable correction, which could begin imminently."
While market calls make the boys and girls on Can Never Be Correct salivate like Pavlov’s dogs, they don’t have a place in an investing process aimed at being consistently successful.
The Concept
The Old Institution believes markets and economies are linear and rational, which is the primary reason their forecasts are garbage and why they never anticipate significant market moves before they occur.
In sharp contrast, we know markets and economies are nonlinear, and to steal a word from science, “chaotic.” This chaotic reality means they share many traits with other chaotic systems like weather and wind turbulence. Naming our Fundamental Gravities after the seasons helps drive home this point. Each Fundamental Gravity season has its own unique playbook for how to trade individual markets and equity sectors.
Spring & Summer Fundamental Gravities
In a Spring or Summer Fundamental Gravity environment, economic conditions and central bank policy favor equities and bonds that behave like equities. This FG is by far the most bullish of all Fundamental Gravity environments. As a rising tide lifts all boats, there isn’t an equity sector that won’t generate positive performance.
That said, to generate the most alpha, allocate most of your assets in the growthy sectors like tech, consumer discretionary, and industrials. From a fixed income perspective, concentrate on convertibles and high yield bonds.
In a Summer FG, you trade as you would in Spring, but you can now add energy stocks, commodities (esp. crude oil, copper), and T.I.P.S. to the mix.
In both FG environments, you want to avoid equities with bond-esque tendencies like utilities, REITs, and consumer staples. On the fixed-income side, treat all durations of U.S. Treasuries like the plague.
Fall Fundamental Gravity
As compared to Spring and Summer, when just about every sector and industry is likely to post positive performance, the Fall FG is a much more nuanced environment to trade.
To generate alpha during the Fall, you’ve got to flip the script and focus on the areas of the equity and bond markets we loathe during Spring and Summer.
In equities, you’re now bullish for utilities and REITs. Tech stocks are still a good choice as are energy stocks because this is the other FG environment with an inflationary impulse. As for your bond portfolio, stay singularly focused on Treasuries, avoiding all durations less than 10-years.
From a commodity perspective, the Fall is the only other time when bullish exposure is condoned, and what worked during the Summer continues to get you paid here: crude oil, copper, gold, or just a broad-based commodities index.
Altogether avoid (long or short) any equity sector or bond market not mentioned here because their risk-return characteristics are not consistent from one Fall FG environment to the next.
Winter Fundamental Gravity
If the Spring Fundamental Gravity is the most bullish environment for risk assets, then the Winter is the polar opposite. There only two equity sectors for your risk capital on the long side: consumer staples and health care. In the fixed income space, avoid all bonds not named “Treasuries” and keep your stash of cash as high as Everest.
Winter is fertile ground for short-sellers and its where all the alpha is generated in this environment. Focus on being opportunistically short energy stocks, financials, industrials, and small caps.
From a commodity perspective, the playbook is straight forward: long gold and short everything else. Be particularly bearish on crude oil, copper, and any other industrial commodity you can get a borrow on.
The Bottom Line
Leave the market prognostications sure to go wrong to Wall Street because you don’t have to be Captain Market Call to be a successful investor. Anchor your decision making in the prevailing Fundamental Gravity, and you will find yourself consistently on the right side of market moves before they occur.
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