The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.
Today, we describe how to view markets in unison through market regime probabilities. Market regime probabilities were the first tools we built to help navigate markets starting in 2020. As such, we have a significantly differentiated perspective on understanding and leveraging them as investors.
Before diving into trading markets, let’s define market regimes. As described in our Macro Mechanics notes, markets price in incremental changes in growth, inflation, and liquidity expectations over time. Said differently, growth, inflation, and liquidity are the principal drivers of asset markets. Importantly, these principle drivers largely operate cyclically, with self-reinforcing cycles upwards and downwards. These cycles drive significant, consistent, and parallel moves across macro markets. As such, macro markets often move in unison over long periods to reflect the most significant growth, inflation, and liquidity changes. Adding up these features into a single definition:
Market regimes are significant, consistent, and parallel movements of macro markets, which reflect the dominant impulses of growth, inflation, and liquidity.
At Prometheus, we think that a rigorous and consistent tracking of these regimes is extremely additive to traditional macro investing. This is because the true state of the macroeconomy is largely unobservable in real time. For all the macro data we use, we are just trying to achieve a high degree of probabilistic understanding of where we are in the economic cycle. To get the best probabilistic understanding of where we are today— we need as much new data as possible, and this is where the macro markets are invaluable. Macro assets offer a high-frequency look into what’s marginally occurring in the economy in terms of growth, inflation, and liquidity. Using quantitative techniques, we can use the information from the combined price action of these markets to estimate the probability of whether the economy is experiencing:
- Rising/Falling Growth
- Rising/Falling Inflation
- Rising/Falling Liquidity
Every regime has its hallmarks. For instance, if we expect equity markets to rise modestly, bond markets to fall significantly, and commodities markets to rally strongly— there is an increased likelihood that we are experiencing a rising inflationary growth environment. Alternatively, if we expect stocks and commodities to fall significantly but bonds to rally strongly, we will likely experience a falling growth environment. If assets rise versus cash and notes, outperform bonds, we are likely in a rising liquidity environment. There are many permutations and combinations of asset market performance, which are too exhaustive to list in this note. Still, the intuition is straightforward: we find more signal strength when a host of markets act like we are in a certain macro environment than if only one does.
Estimating today’s macro regime helps us add significant refinement to our economic nowcasting process and significantly improves overall portfolio performance. However, it is crucial to recognize that every regime probability, when used to guide investors, is an implicit forecast of the future. We cannot trade today’s regime, only tomorrow’s regime. This means that simply extrapolating today’s regime forward is inadequate, as it biases one towards trend following. Trend following is an excellent strategy for most investors to consider. However, excess bias toward trend-following can lead to large periods of mediocre performance as trend factors get crowded. Therefore, knowing today’s regime can be a part of a system’s signal generation— but it should not depend on it. Every position you take in markets is an effective bet on what the market regime will be tomorrow; you shouldn’t bet it all on it just like yesterday.
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