Forecasts Are a Fool's Errand
07/20/2017 2:53 am EST
Thomas Carlyle, a Scottish philosopher, once said, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.” Mr. Carlyle would have made one hell of a global macro investor.
The two most important factors impacting asset prices are economic conditions and how central banks respond to those conditions. When you evaluate the global economy, successful investing demands that you focus on better understanding what’s happening right now, or what lies clearly at hand. This is a huge advantage over other investors because most are focused on three-month-old data or forecasters who claim to know what’s going to happen months in the future.
I’ll be the first to admit that talking about current economic conditions isn’t as entertaining as watching a guy push sound effect buttons while rattling off a bunch of stock tickers until he has you investing in every company in the Wilshire 5000. But if you can understand the impact that growth and inflation have on asset prices, then you can gain insights into risks and opportunities that other investors miss.
Since last week, it appears the world has started to drink my Kool Aid because all anyone can talk about is U.S. inflation. The problem is that they believe inflationis the key to forecasting the Fed’s next move.
Forecasts and mirages
“Forecasts create the mirage that the future is knowable.” Well said, Peter Bernstein, well said. Most pundits, gurus and investors seem to be under the impression that the Fed can’t possibly raise rates again this year if inflation remains below their mandated threshold of 2%. As a reminder, US inflation peaked at 2.7% back in February and has declined each month since and now sits at 1.6%.
These people have very short memories indeed. Back in December 2015, when Ben Bernanke raised rates for the first time in a decade, he did so when inflation was running below 2%.
What’s more, he raised rates right into a U.S. economy that had been slowing for three consecutive quarters.
His policy error caused global markets to hit the skids the very next month, with the S&P 500 losing 13% in just three weeks. Bernanke’s blatant disregard for the economic data also caused a U.S. industrial recession, which lasted over six months. My point is that believing the Fed is data dependent is like believing WWE wrestling is real.
It’s even more asinine to use that flawed “data dependent” assumption to forecast the Fed’s next move.
This time is no different, and you can’t possibly manage a portfolio today based on what the Fed might, or might not, do two to five months from now. The most important action you can take is to position yourself based on the information that economic data and financial markets are providing you right now.
Just the facts, ma’am
In order to position your portfolio properly, it’s important to pay attention not only to inflation, but also to the growth part of the economic equation. For the first two quarters of this year, U.S. economic data has confirmed accelerating growth.
Although economic data is generally lagging, financial markets are confirming this acceleration in real time. I track two proprietary indices to help me gauge the trajectory of U.S. economic growth in between monthly and quarterly economic reports.
My U.S. High Growth index is comprised of assets that perform well when U.S. growth is accelerating. On the other side, I have my U.S. Slow Growth index, which is made up of assets that, you guessed it, perform well when U.S. growth is slowing. These two indices have a great track record of nailing the direction of U.S. economic growth in real time.
As of July 20, 2017, my High Growth index had outperformed the Slow Growth index by 400 basis points. This outperformance has been consistent all year. The High Growth index has outperformed Slow Growth in every month of 2017, and that outperformance is continuing in the first three weeks of Q3.
When U.S. growth accelerates during periods of declining or lower inflation, the playbook is: invest in the go-go growth sectors of the U.S. economy, like tech and small cap stocks, while avoiding asset classes that are sensitive to higher yields, like gold and gold-related equities.
Historically during this type of economic posture of growth up and inflation down, small cap stocks deliver double-digit returns with single-digit drawdowns. On the flip side, gold and gold-related equities typically lose value, while experiencing double-digit drawdowns.
I don’t know about you, but whenever I experience “double digits” with my portfolio, I prefer it to be on the performance side of the ledger, rather than the risk side.
The Long Trade Idea
You can get long US small cap growth companies via the iShares Russell 2000 Growth Index ETF (IWO).
As long as IWO trades above $160.50, then you can use declines to initiate new long trades. Depending on where you enter the trade and how much room to move you want to give this trade, you can use a risk price between $165.04 and $160.50. That said, your risk price line in the sand is $160.50, if IWO closes below that price, then you should exit any open trades.
If the trade moves in your favor, I would book profits on any rally to the $174.67 to $175.03 range.
The Short Trade Idea
You can get short gold via the SPDR Gold Trust ETF (GLD).
As long as GLD trades below $121.90, then you can use rallies to initiate new short trades. Depending on where you enter the trade and how much room to move you want to give this trade, you can use a risk price between $118.68 and $121.90. That said, your risk price line in the sand is $121.90, if GLD closes above that price, then you should exit any open trades.
If the trade moves in your favor, I would book profits on any decline to the $114.80 to $113.97 range. There is a lot of support there and it will be difficult for GLD to break down through it.
The Bottom Line
Remember, it’s said there are no facts about the future, only opinions.
Make sure your opinions about the future are rooted in being data-dependent, process-driven and risk conscious. Right now, the data says U.S. growth is accelerating and inflation is slowing. The process says to be long U.S. growth sectors like small cap equities. And risk consciousness says to avoid (or opportunistically short) markets that are sensitive to higher yields, like gold and gold-related equities.