Our Main Business

Thomas Carlyle, a Scottish philosopher and one of the most important social commentators of the nineteenth century, once said, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.” Mr. Carlyle would have made one hell of a global macro investor.

Regular readers of Vague Destination know that I routinely channel my inner Joe Friday because all I need are the facts and just the facts. In financial markets, the “facts” are data about economic growth and inflation because these are two of the most important factors impacting asset prices. When you evaluate the facts, successful investing demands that you focus on better understanding what’s happening right now, rather than three-month-old data or forecasters who claim to know what’s going to happen months in the future.

I’ll be the first to admit that talking about current economic conditions isn’t as entertaining as watching a guy push sound effect buttons while rattling off a bunch of stock tickers until he has you investing in every company in the Wilshire 5000. But if you can understand the impact that growth and inflation have on asset prices, then you can gain insights into risks and opportunities that other investors miss.

Since last week, it appears as though the world has started to drink my Kool Aid because all anyone can talk about is U.S. inflation. The problem is that they believe inflation is the key to forecasting the Fed’s next move.

 

Lost in Translation

Last week, most investors zeroed in on Yellen’s statement: “There is, for example, uncertainty about when, and how much, inflation will respond to tightening resource utilization.” Some media outlets reported that she over-emphasized the uncertainty about inflation. But as is true in all areas of life, context is everything. Her remark about inflation’s uncertainty was meant as an example of the uncertainty that is always present when you’re dealing with something as complex as the global economy.

Remember, there are no facts about the future, only opinions.

Nonetheless, people translated the totality of her statements as dovish, and decided she has now signaled no more rate hikes this year.

 

Forecasts and Mirages

“Forecasts create the mirage that the future is knowable.” Well said, Peter Bernstein, well said. Most pundits, gurus and investors seem to be under the impression that the Fed can’t possibly raise rates again this year if inflation remains below their mandated threshold of 2%.

These people have very short memories indeed. Back in December 2015, when Bernanke raised rates for the first time in a decade, he did so when inflation was running below 2%.

What’s more, he raised rates right into a U.S. economy that had been slowing for three consecutive quarters.

His policy error caused global markets to hit the skids the very next month, with the S&P 500 losing 13% in just three weeks. Bernanke’s blatant disregard for the economic data also caused a U.S. industrial recession, which lasted over six months. My point is that believing the Fed is data dependent is like believing WWE wrestling is real.

It’s even more asinine to use that flawed “data dependent” assumption to forecast the Fed’s next move.

This time is no different, and you can’t possibly manage a portfolio today based on what the Fed might, or might not, do two to five months from now. The most important action you can take is to position yourself based on the information that economic data and financial markets are providing you right now.

 

Just the Facts, Ma’am

Just to be clear, slowing inflation is not only a U.S. issue. Inflation is slowing globally, most notably in China. It will prove very difficult for U.S. inflation to pick up steam, and maintain it, without inflationary help from abroad.

In order to position your portfolio properly, it’s important to pay attention not only to inflation, but also to the growth part of the economic equation. For the first two quarters of this year, U.S. economic data has confirmed accelerating growth.

Although economic data is generally lagging, financial markets are confirming this acceleration in real time. I track two proprietary indices that I developed to help me gauge the trajectory of U.S. economic growth in between monthly and quarterly economic reports.

My U.S. High Growth index is comprised of assets that perform well when U.S. growth is accelerating. On the other side, I have my U.S. Slow Growth index, which is made up of assets that, you guessed it, perform well when U.S. growth is slowing. These two indices have a great track record of nailing the direction of U.S. economic growth in real time.

As of July 14, my High Growth index had outperformed the Slow Growth index by 400 basis points. This outperformance has been consistent all year. The High Growth index has outperformed Slow Growth in every month of 2017, and that outperformance is continuing in the first two weeks of Q3.

When U.S. growth accelerates during periods of declining or lower inflation, the playbook is this: invest in the go-go growth sectors of the U.S. economy, like tech and consumer discretionary stocks, while avoiding gold and long-dated Treasuries.

Historically during this type of economic posture, U.S. tech and consumer discretionary stocks deliver double-digit returns with single-digit drawdowns. On the other hand, gold and long-dated Treasuries typically lose value, while experiencing double-digit drawdowns.

I don’t know about you, but whenever I experience double digits with my portfolio, I prefer it to be on the performance side of the ledger, rather than the downwards side.

 

The Bottom Line

Trust me, I know how easy it is to get caught up in narratives and Wall Street forecasts. Hating uncertainty is engrained in our DNA, which is why investors crave forecasts like a fat kid craves Cook Out milkshakes.

When it comes to making investment decisions, ignore the media and the forecasts, and focus your energy and resources on better understanding what’s happening right now. Right now, the data says U.S. growth is accelerating and inflation is slowing. The process says to be long U.S. growth sectors like tech and consumer discretionary. And risk consciousness says to avoid gold, bonds and bonds’ equity cousins until the fundamentals change.