How to remove human biases and build an "all-weather" portfolio?

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"The ability to forecast the consequences of "arbitrary", unannounced sequences of policy decisions, currently claimed (at least implicitly) by the theory of economic policy, appears to be beyond the capability not only of the current-generation models but of conceivable future models as well… in short, it appears that policymakers, if they wish to forecast the response of citizens, must take the latter into their confidence"

Nobel laureate economist Robert E. Lucas, Jr. (1937-2023), in a 1976 article (excerpt above), introduced the world to what is now known as the "Lucas critique" of macroeconomic models. What he said was that when expectations about government policy change, the models used for predicting the results of fiscal and monetary policies become useless.

This article is as relevant today as it was almost five decades ago and is a critical lens when we think about different outcomes that participants are juggling with, namely:

1) Stagflation(higher inflation and lower growth), 2) Disinflation (lower inflation and stable or higher growth) or
3) Deflation (lower inflation and no growth or recession)

The economic, political, geopolitical and financial market outlook remains uncertain, but understanding these dynamics is crucial for navigating what lies ahead. The outcomes for asset prices would be different across each of these scenarios. Louis-Vincent Gave shared an interesting blueprint to assist in navigating this landscape.

Economists and market participants were quick to move to the bottom right quadrant after the US Consumer Price Index (CPI) and US Retail sales data released last week.

Much weaker-than-expected retail sales (0.0 percent month-over-month versus 0.4 percent expectations) and marginally weaker inflation (Headline CPI 0.3 percent month-over-month versus 0.4 percent expected) pushed Equities to all-time highs, yields lower, the dollar lower, and gold/commodities higher. Participants firmed up expectations of Fed rate cuts in September and December. Even "meme" stocks were back with a bang.

Are financial markets once again moving ahead of themselves?

Sir Isaac Newton once said, "I can predict the movement of heavenly bodies, but not the madness of crowds". Clearly, financial market cycles are getting shorter, hotter, and faster. US 10-year yields rallied from their highs of 5.02 percent on October 23, 2023, to 3.78 percent in a short span of two months. That is a 25 percent move and bigger in percentage terms than even during the collapse of Lehman Brothers at the peak of the Great Financial Crisis (GFC) 2007/08.

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While cracks are beginning to emerge in pockets of US data and valuations are rich in comparison to long-term averages, positively, US corporate earnings growth remains robust. According to FactSet, the blended earnings growth (combines actual and estimated results) year-over-year earnings growth rate for the S&P-500 market barometer is 5.4 percent for the quarter, up from 3.4 percent at the end of March 2024. If Bristol Myers Squibb were excluded, this number would improve to 8.3 percent from 5.4 percent.

How does one prepare for these different outcomes?

It may be futile to predict the outcome – whether we are stagflation, disinflation, or deflation (remember Chairman Powell hiked interest rates in the US by 75bps almost a year after he made the famous statement in March 2021 that "inflation was transitory").

Instead of picking sides, creating a well-diversified, "all-weather" portfolio that includes a mix of Global and Domestic Asset classes would be prudent.

Just like it is nearly impossible to time the entry and exit of stocks, it is also nearly impossible to consistently time the entry and exit of asset classes. One must maintain a balanced allocation among various asset classes based on their long-term return targets, liquidity needs and ability to tolerate stretches of uncertainty.

An all-weather portfolio would have an optimal mix of the following asset classes:

1) Traditional market assets (Equities and Fixed Income),
2) Inflation-protecting assets (Diversified physical assets, Commodities) and
3) Aspirational assets (Alternates or Private assets)

It would reduce human behavioural biases, improve risk-adjusted returns, and enhance overall portfolio performance.

More importantly, it would prevent us from reacting to short-term market events or trends that may quickly reverse. Most investors forget that effective investing requires being counterintuitive (buy what you hate and sell what you love). Of course, this is easier said than done.

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Market participants, economists, and policymakers would be better prepared to heed Lucas' critique before "arbitrarily" changing outcomes.

We can even apply Lucas' critique to the plethora of recommendations ahead of the election results in the world's largest democracy. With less than two weeks to go before the results and the psephologists working overtime to predict them, are we making a mistake by simply extrapolating the policies and views of the last two terms? What if people's expectations change? The incumbent would have to incorporate this change in expectations (whether rational or irrational) as they draft future economic policies. The outcomes would be glaringly different.

Prashant Tandon is senior director for listed investments at Waterfield Advisors.

The thoughts and opinions shared here are of the author.