As the year approaches its finale, money managers are celebrating their triumphs (and minimizing any failures). The good news is that there’s ample opportunity for emphasizing the former. Barring a year-end surprise, US stocks and bonds in particular are on track to end 2014 with solid gains. Wall Street won’t be shy in taking most if not all of the credit for juicing the value of client portfolios. But let’s take a minute and recognize the primary source for the gains over the past year: economic growth.
Critical Factor
Genius has been a bull market in 2014 and the critical factor behind this ascent has been a familiar influence in recent years: a rising economic tide in the US. Saying so isn’t free of controversy, in part because more than a trivial degree of the positive macro trend is bound up with the surfeit of liquidity that’s been engineered in central banks around the world. By some accounts, the economic expansion in the US is artificial, courtesy of the Federal Reserve’s monetary machinations. Maybe so, but a synthetically powered expansion is just as profitable (if not more so) than one that arises organically.
Accordingly, let us give thanks to the main source of holiday cheer that accompanies year-end performance statements these days: the economy. The bullish macro trend in the US may be unloved, but celebrated or not the economy is responsible for the abundance of plus signs in US-centric year-to-date portfolio updates.
In the search for reasons why your investment strategy was successful, the US macro factor surely casts a long and, for now, positive influence. Financial economists have identified dozens if not hundreds of factors for deconstructing risk premia. But the leading factor is still the economy, for good or ill, and that’s not going to change.
History Suggests
If you could know only one thing about the year ahead in the cause of enhancing the quality of portfolio decisions, what would you choose? History strongly recommends the mother of all known risk factors: the business cycle. The economy’s capacity for steering clear of recession, or not, dictates portfolio outcomes to a large degree, even if our egos have a tendency to assign credit for investment success to other sources. Mr. Market may be irrational at times, but he’s crazy like a fox when it comes to favoring economic growth–and running for cover when the business cycle slides over to the dark side.
A bullish tailwind that’s blowing through the economy is too often confused with talent. Earning a profit on a portfolio of risky assets isn’t easy, but it’s a lot tougher if your strategic assumptions conflict with the directional bias of the macro trend. It’s no accident that the overwhelming majority of investment products are designed as long-only bets. Why? Because of the generally accurate view that growth will prevail through time.
Growth won’t save everyone from investment failure, but it does wonders in providing cover for long-only closet indexing products that masquerade as active management. Macro also explains quite a lot of success (or failure) with asset allocation decisions. It’s widely recognized that your choice of weights for stocks, bonds, real estate and commodities is the main driver of risk and return fluctuations in portfolios. But when’s the last time you heard someone pay homage to the business cycle as the source for validating (or nullifying) preferences in portfolio design?
The good news is that recession risk is virtually nil at the moment, which means that earning a risk premium has been relatively easy. This happy state of affairs won’t last forever, of course, which is why developing a macro view of the near-term future should be the first order of business in the design and management of investment strategies. That’s a radical idea in some circles, but it’s really just a keen grasp of the obvious.
There’s still no consensus for explaining why economies go through alternating phases of growth and contraction, but there’s an obvious reason why many (most?) investment portfolios are sitting on handsome year-to-date gains as 2014 draws to a close.