Benjamin Franklin believed in free trade. “No nation was ever ruined by trade,” he said, adding, “even seemingly the most disadvantageous.”

Now fast forward to equity markets today; world trade in volume is one of the seven macro rules embedded in the artificial brain of TrackMacro, Gavekal-IS’ software providing real-time investment portfolios.

Last month, TrackMacro issued a “strong” signal on trade. World trade is anticipated to boom.

Does this mean equities should rally?

Some forty years ago, Charles Gave introduced the “Four Quadrants” concept, used by generations of investors to drive asset allocation in global investment portfolios. The concept crosses inflation and growth to cluster four macroeconomic situations: inflationary boom, inflationary bust, disinflationary boom, and disinflationary bust.

Here we revisit the concept with a scientific eye, applied to ecosystems. We focus on the second derivative of economic production or asset prices, i.e. the acceleration or deceleration of growth and inflation, intentionally ignoring the levels of inflation and growth. A new “Four Quadrants” is born, bridging macroeconomy and simple mathematics. It massively amplifies Charles’ discovery decades ago.

What is it telling us? That the US game on equity price-earnings’ expansion is over.

Equity holders are brave investors who abandon their capital forever (unless they find a third party in the marketplace to replace them, which is never guaranteed) against a flow of uncertain future dividends. Companies, therefore, must distribute dividends, and they can only do so in two ways: they either pay dividends on capital if earnings are sufficient, or they pay dividends off capital.

The worse of the two is the latter and leads to capital destruction. So, who is responsible? The most influential macro factor on portfolio construction for long-term investors, today on the verge of resurfacing: inflation.

Inflation kills equity returns. This has been the case for more than a century in the US, and nearly all countries in the last twenty years, as evidenced in this letter.
So, are we in – or about to enter – the dangerous territory, turning the equity dream into an equity nightmare?

Our previous publication, The Mason’s Strategy, underlined the longstanding and intriguing forecasting power of behavioral finance. Today, our masons go back to the university to study macroeconomic sciences and specifically where stock markets go. This time, they want to know in a purely objective manner.

Will they succeed?

Notre dernière publication, La Stratégie du Maçon, dévoilait la surprenante puissance prédictive de la finance comportementale. Aujourd’hui, nos maçons retournent sur les bancs universitaires pour étudier les sciences économiques. Ils veulent découvrir, cette fois de manière purement objective, où vont les marchés.

Vont-ils réussir ?

To check the horizontality or verticality of a wall, masons still use an ancestral instrument today known as the “Spirit Level”. Now, let us use this instrument to measure the psychology of the equity markets to warn us when they start to tilt in the wrong direction, at the risk of collapsing the edifice.

Pour vérifier l’horizontalité ou la verticalité d’un mur, les maçons utilisent encore aujourd’hui un instrument ancestral : un Niveau à Eau. Nous allons utiliser cet instrument pour mesurer la psychologie des marchés actions et pour nous avertir quand ils commencent à pencher du mauvais côté, au risque d’écrouler

There is a generally accepted way to measure inequality within a nation or group of people – the Gini coefficient – and there is also a not-so generally accepted measure of freedom, this time provided by the Heritage Foundation. There must be some sort of a trade-off between equality and freedom, and there is.

In half a century of doing financial analysis, Charles has acquired the core conviction that there is not one type of bear market, but two. Think of these as the gentle black bear-type downturn that is survivable and the highly-dangerous, big brown grizzly collapse that for many money managers proves fatal. In this piece, Charles seeks to map this insight with some analytical rigor.

Fragility in finance is equivalent to mass in physics. To understand the analogy, one must go back to the origin of time itself. Crucially, the genesis of our universe is remarkably similar to the genesis of finance. This claim shall lead us to a better understanding of what antifragility means. Antifragility in finance is equivalent to antimass in physics, the hypothetical ‘dark energy’ that has eluded cosmologists for so long.

This letter presents visual analogies between quantum physics and market behaviour with regards to risk memory. As shown in the previous publication, market risk memory exists, which is inconsistent with the theoretical picture proposed by traditional financial mathematics. Such an inconsistency, between theory and reality, is at the heart of quantum physics, known as the wave-particle duality. As for particles, represented by wave functions, market distribution of returns are distorted by intercations, i.e. transactions. Such distortions can be measured, and affect all common financial risk measures, such as Value-at-Risk.