Financial markets move slowly, and then suddenly they’re off, all at once. This is why successful investors have well-greased neck joints: they keep their head on a swivel.
Success is about distilling critical market developments consistently and accurately. The best way to do this is to gather and condense economic and financial market data using a Bayesian approach.
I’m not going to geek out on you about my boy Thomas Bayes, but suffice to say, he provided us with a much better way to evaluate markets than the static reasoning used by most investors.
With static reasoning, the future is viewed as a single outcome that is knowable. Investors apply this reasoning to markets and then position themselves to profit if they’re right. Unfortunately, because they are all-in on a single outcome, this approach exposes them to heavier losses if they turn out to be wrong.
Static reasoning exacerbates our humanness, making it a less than desirable way to evaluate markets. First, it drips with overconfidence bias because it forces you to take a firm stance as well as ownership of your market perspective. Second, it is subject to confirmation bias because our humanness forces us to process new information against the backdrop of our convictions.
In contrast, Bayesian reasoning begins with a flexible hypothesis, which is consistently updated as new economic and financial market developments occur. The benefit of this approach is that it offers you the ability to quickly change your market perspective if the data dictates.
With static reasoning, investors create a market perspective and dutifully trade from that perspective. With Bayesian reasoning, an investor’s market perspective is fluid, and he or she trades with an open mind as new developments occur.
Right now, investors using static reasoning to trade markets in the U.S. are about to be blindsided by inflation’s next move. However, those of us on Team Bayes can use their inertia to our advantage.
I made the call early in the year to be long U.S. technology stocks and short U.S. energy stocks. This Macro Theme was driven by the hypothesis that U.S. growth would continue to accelerate in Q1 2018, while inflation slowed. When I made that call in mid-January, the “inflation slowing” call was radically contrarian. Everyone was doing their best Jackie Gleason impersonation calling for U.S. inflation to go “to the moon, Alice.”
With the benefit of hindsight, I nailed the trade but slightly missed the inflation call. U.S. inflation did not outright slow; it simply stopped going up. Nevertheless, the trade worked in spades!
Since making the call on January 18, the trade has gained 5.7%, while the S&P 500 has declined 4.3%. I’d say 1000 basis points of outperformance over three months is the textbook definition of “nailed it!”
I was quite clear in that commentary: “When this sequential slowing occurs, investors are going to be quick to re-evaluate their “up, up and away” view on inflation. This consensus view tells me that even a minor downward shift in inflation expectations could have a profound impact on the prices of reflationary assets, such as energy stocks.”
Inflation’s subsequent two-month breather did indeed have a profound impact. It was enough to plunge energy stocks into a peak-to-trough drawdown of −17.9%. That’s damn near crash mode, which is technically defined as a peak-to-trough drawdown of more than −20%.
But as S.E. Hinton once wrote, “That was then, this is now.”
The Power of Now
I’m not one to rest on my laurels, and I’m always firmly guided by the principle of understanding what’s happening right now. With that in mind, it’s time to change our playbook. This is because the data and our Bayesian approach dictate that we should do so.
After hibernating for the remainder of winter, U.S. inflation is now locked, loaded and ready to roll. The inflation growth rates from March, both headline and subcomponents, are back on fire and headed higher.
Consumer prices (CPI) accelerated to +2.4% in March, from February’s +2.2% reading, which is the fastest pace of growth in twelve months. Core inflation hockey-sticked to 2.1% in March, marking the first acceleration in four months and the fastest pace of core inflation growth in a year. Producer prices round out the big three of inflation, and they accelerated for the third consecutive month and remain at their highest levels since 2011.
The one contrarian data set, which decelerated, was the price of energy-related commodities. However, I expect this subcomponent to become a tailwind for U.S. inflation going forward, as the feedthrough impact of elevated crude oil prices begins to have its say.
The FG bottom line is that inflation has been dormant to start 2018, but that slumber is over and there is a high probability that it will accelerate from here.
Quantitative Gravity Says What?
For U.S.-based energy companies, there are two primary ETFs which can be used as proxies to evaluate that sector as a whole: SPDR S&P Oil and Gas Exploration ETF (XOP) and the Energy Select Sector SPDR ETF (XLE).
I favor XOP in this environment because it gives you a bit more “pop” than XLE, so I’m going to give you the rundown on its Quantitative Gravity.
For the uninitiated, our QG framework is not “technical analysis.” You’ll never hear us discuss head and shoulders patterns, abandoned babies, or other valueless indicators like the MACD. Instead, we harness the power of Chaos Theory to more accurately quantify the underlying dynamics of market structure.
Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price. Price is the messenger, not the message; to glean valuable quantitative insights about financial markets, we must look well beyond price.
Specifically, we’ve identified the four main quantitative dimensions of financial markets that affect price movement: energy state (trend), force (momentum), rate of force (buying/selling pressure), and the level of a market’s irregularity.
Social is our measure of a market’s current energy state, or trend. Like many other equity markets around the world, XOP started 2018 in full party mode. However, it spent February nursing a hangover and most of March sleeping it off. Then four days ago, XOP woke up to party mode once again.
Momo is our measure of the amount of force behind the market’s current trend. XOP’s Momo bottomed on February 7, two days before its price bottomed, and has been building bullishly ever since. Momo has now been positive for 21 consecutive trading days and is sitting at its highest level since mid-January.
Barometric is our measure of the rate of force (buying/selling pressure) behind the current Momo. XOP’s Barometric has been building buying pressure since March 16 and is currently sitting at its most bullish reading since mid-December. The last time XOP’s Barometric reading was at this level, it preceded a three-week, 18% gain.
Finally, Topo is our measure of a market’s irregularity and it helps us handicap the probability of a drawdown. I’ll keep this one simple: when a market is rallying, then a declining Topo confirms the upswing. XOP’s Topo peaked in the first week of April and has been declining during XOP’s latest two-week rally.
The QG bottom line is that the underlying market structure of XOP has been showing signs of living the bullish life for weeks now, and price is beginning to play along.
Behavioral Gravity Says What?
Our proprietary Behavioral Gravity Index (BGI) is our approach to quantifying investors’ perception of a market at a given point in time and how that perception is changing as we move through time.
Both XOP and XLE’s current BGI readings are near the most bearish readings in the last twelve months.
During XOP and XLE’s massive rally to start 2018, investors plowed over $1B into these ETFs. However, since January 24 (the 2018 price peak for both ETFs), the funds have declined −6.7% and −7.7%, respectively. This drawdown led to investors yanking close to $800MM in assets collectively from XOP and XLE. This is a great example of investors being plagued by their static reasoning.
The BG bottom line is that investors are running for the doors when they should be anchored to the couch, eating popcorn, and waiting for the energy show to start.
The Bottom Line
To be a consistently successful investor, you must change your perspective when the data changes.
Notice that I didn’t say you must change when the narrative changes. Also note that I didn’t once mention Trump, Xi, tariffs or trade wars. The reason is simple: these topics drive media commentary and website clicks, but it’s the direction of boring old inflation that has the most dramatic impact on your overall portfolio.
If other investors want to react to every Bloomberg headline and Trump tweet like a cat chasing a laser pointer, let them. Remain data-dependent and use their crazy-cat reactions to position yourself for where the puck is going, not where it’s been.