Countercyclical Asset Allocation
We have spent a good share of our energy and resources in the past two years trying to understand how to invest during major market crises. As we argued in Crisis Investing, when pessimism is highest, when others are scared, investors should overweight illiquid small-cap value stocks and high-yield bonds. But what to do when we’re not in a crisis, when sentiment is bullish and there’s no bad news on the horizon?
We have tried to build an asset allocation model that captures the opportunities in crisis while avoiding major losses from negative shocks to growth or positive shocks to inflation during normal market environments. This approach has three defining features.
First, we build on our Crisis Investing research, relying on business cycle indicators, the high-yield spread, and the slope of the yield curve to estimate the stage of the business cycle and isolate three consequent economic states: growth, inflation, and slowdown.
Second, we complement our business cycle indicators with a trend-following approach, relying on recent price trends to help hedge against short-term negative shocks to growth and positive shocks to inflation.Third, we attempt to maximize returns in each economic state through asset allocation, which is informed by our analysis of the sensitivity of different asset classes to changes in the rate of growth and inflation.
Our countercyclical investing approach is designed to achieve three objectives:
We show the results of a back-test of this strategy below:
Figure 1: Comparative Performance Over Full Period (1970–2020)
Source: Bloomberg, Capital IQ, Global Financial Data, Verdad. Countercyclical Investing portfolio rebalanced quarterly, transaction costs not included, $ rounded to nearest thousand.
This paper is a framework for thinking about how to use macro-economic analysis to make asset allocation decisions. The paper’s scope does not include implementation or alpha generation within asset classes.
We have distilled our study on countercyclical asset allocation into a 50-page in-depth report. Over the next three weeks, we will highlight a few key sections of the report. We have also included a link to the full report below. We hope you enjoy reading our new study.