Managing portfolio risks has nothing to do with massaging the average volatility; it is all about not being caught in violent market bifurcations. There are ways not to time bifurcations, but time the risk of bifurcations. Why? Because like nature, financial markets exhibit measurable fractal forms for the better, and for the worse.

This letter introduces fractality for two reasons:

Two weeks ago, a friend of mine lost his tennis racket on the highway. The racket fell right out of his bag attached to the back of his motorcycle. He quickly took the first exit, returned to the spot, pulled his motorbike into the emergency lane, and spotted his racket lying there on the highway. Did he end up crossing the road to retrieve it?

Managing risk does not mean forecasting.

Will the financial market crash?

This is anyone’s guess; the future is unpredictable. But what about the risk?

Given the inflationary shock on oil developing month after month, the odds of a 50% drawdown on the S&P 500 have been multiplied by a factor of 100.

For seven months in a row, Gavekal-IS macro, monetary, and behavioral models remained very equity-friendly, serene as a Tibetan monk. In the meantime, Gavekal-IS publications displayed a series of macroeconomic warning signals building up for a potential climax around August or September. See for instance February’s “Inflation: The Equity Nightmare,” and “US PE Expansion: Game Over!” publications, and May’s “Economic Boom and Financial Bust.”

Today, Gavekal-IS models crossed the Rubicon: criticality is ahead, risk-off!

In a series of three publications in February 2021, we explained how accelerating inflation – not simply high inflation – had been awfully bad news for equities for 140 years. Some of our readers argued that rather than inflation, interest rate was the key driver of equity behavior. If central banks continued using their purchasing power to cap government bond rates at low levels, equity markets should be fine.

Here, we refocus our analysis on interest rates, and our conclusion remains the same: last round for equities!

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.

Gavekal-IS is excited to announce the launch of its new TrackMacro 3.0 application! The app is downloadable on the website with free access for one month. TrackMacro 3.0 is a major technical step concentrating years of financial research in portfolio construction.

So, how does it work?

Gavekal-IS proposes a 3-dimensional perspective on portfolio construction: macroeconomic, monetary, and behavioral. In each dimension, we straightforwardly consider which of two opposing economic theories is in the ascendancy:

Today, the world votes for Smith, Keynes, and Markowitz.

Injecting liquidity into the stock market is a bit like taking an aspirin when one feels sick. It lowers the fever (a short-term relief), sometimes at the expense of long-term recovery.  Could it be that printing money extensively and cutting rates to low levels for too long increases market fragility as well?

For the first time since the end of the subprime crisis in 2009, the S&P 500 book stopped growing on December 31st, 2020 over 12 rolling months. The US market momentum is therefore fully supported now by intangible value.