The following is part one in a series written by Hunter Frey, Investment Analyst at Catalyst Funds, Rational Funds, and Strategy Shares.
The second quarter of 2022 continues with intense volatility. Both equity markets and bond markets continue to unravel the complexities of supply constraints, stagflation, hawkish Fed policy (and the velocity of rate hikes), slower domestic and global economic growth, geopolitical headwinds (i.e., the Russia-Ukraine war), the commodity “Supercycle,” persistent COVID-19 demand woes (i.e., China lockdowns), and potential Gray Rhino events (spurred by fears of the current environment). Recessionary fears and a flight to safety remain investors’ top priorities.
The US dollar remains one of only a handful of asset classes that have provided marginal gains with a YTD return of +6.97% vs. the S&P 500 Index at -17.03% and the Bloomberg US Aggregate Bond Index at -9.50%. Energy and soft commodities provided outsized gains throughout the first quarter amid geopolitical tensions between Russia and Ukraine (both critical countries for energy, industrial metals, and grains). However, as the second quarter began, energy became handicapped by China’s demand worries amid their Zero Covid policy lockdowns and nondefinitive EU energy sanctions on Russia (particularly Hungary’s hold out). With domestic reserves approaching concerning levels, energy’s battle between supply and demand may persist, limiting upside returns over the next few months as volatility overshadows. Soft commodity returns and the overall commodity “Supercycle” have become more selective, allowing active commodity managers to generate index beating gains.
Technology, especially large-cap tech stocks and pandemic “sweethearts,” continue to whipsaw amid recession fears and rising rates. Other sectors (including technology) remain reliant on earnings results, either intensifying downward market pressures or offsetting some near-term losses. However, one major takeaway from the post-COVID market is that value investing’s prolonged 12-year underperformance (compared to growth) may be over.
With valuation multiples artificially inflated due to intense buying throughout the pandemic amid government stimulus and higher cash reserves, growth stock’s valuation recalibration continues to be aggressive. For instance, the S&P 500 Growth Index return was -25.55% (as of 5/11/22) compared to the S&P 500 Value Index’s return of -7.75% (5/11/2022). Though equities continue to experience headwinds, value’s opportunities may generate attractive risk-adjusted returns compared to growth. With the S&P 500 Index’s technical recessionary support (at $3600), valuation quality may continue to deliver alpha.
Amid the current economic backdrop, cross-asset underperformance may be here to stay. However, many recessionary fears have already been priced into the market for equities and fixed income (graph here). Unfortunately, that does not mean much during a thematic environment plagued with uncertainty. As you will read, hear, or assume, investors (by the masses) have become risk averse. For context, risk aversion is when investors limit risks by investing in haven assets (with certainty), forgoing higher riskier gains. On the other hand, less attention has been attributed to illustrating that investors have congruently become increasingly loss averse (which is very different). Loss aversion is when losses have a more significant psychological impact than foregone gains (or when investors take on more risk to regain losses). Both thought processes have their pitfalls, but when investors combine these perspectives, the outcome may be catastrophic to returns (as we are witnessing now). As we have experienced throughout 2022, the result of the risk-averse, loss-averse cocktail is “volatility” and bear market rallies. The combination produces a higher chance for active investors to double down on losses. However, if investors fundamentally understand this dynamic and the market repercussions, active managers/investors can generate alpha and minimize downside underperformance.
The Machine Learning Advantage
With this said, , it remains difficult for human investors to minimize these basic human behaviors and the cognition of prospect theory’s mechanics described in “Behavioral Economics: The Psychological Shifts Driving the Current Financial Ecosystem,” Therefore, alternative machine learning supported investment strategies may be the best option during times of investor uncertainty and the diminishing sensitivity to returns (both losses and gains). As we look forward to the rest of 2022, we continually ask ourselves: Where is the bottom? Can we time the market? Should I invest? All these questions are valid, but the answer is opaque. Trying to answer these questions leads to mistakes and compounded losses. Nonetheless, investors must decipher the dynamic current events, economic data, and overall sentiment to compile a reasonable perspective/forecast on the overall market. Patience, control, and contained confidence remain the attributes to weather the current environment.
Psychological characteristics aside, many investors struggle to synthesize the answers to this question because they believe that “forecasting” is unreliable. However, this subjective reasoning of “forecasting” is embedded in every fundamental decision. So, forecasting is not impossible; instead, it is a skill set. As Herbert Simon said, individuals (investors) have bounded rationality, producing the dilutive effect of biases. Therefore, investors must minimize these innate biases. One way to reduce biases is to follow a rules-based approach or a systematic machine learning strategy (with the originator aware of these cognitive constraints). It is also pivotal to translate the usage of these machine learning algorithms into comprehendible terms as it is not as complex as initially perceived. As Phillip Tetlock explained in his book “Super Forecasting: The Art and Science of Prediction,” the ability to statistically forecast return potential resides in how the current situation and the agility of current models adapt to dynamic information. Thus, the secret to returns during uncertain markets resides in how the investor (or the machine learning algorithm) thinks, gathers information, and updates beliefs/expectations. Thus, stripping out the regressive psychology of excuse maintenance of knowledge understood remains pivotal to successful bear market investing (though we are not in a bear market yet).
As highlighted in “The Most Valuable Hidden Gem: Investors Should Seek the Hybrid Approach,” systematic strategies with the ability to capitalize on macroeconomic events through global equity, currency, commodity, and interest rate instruments enables the agility of portfolio returns during periods of uncertainty. Therefore, investors must remain agnostic and tactical over the next 12 months. However, that does NOT mean to avoid investing. Not investing and overweighting risk aversion enables your mental accounting to minimize retracement performance when the recessionary fears are completely priced into the markets and upside potential resurfaces.
Investors should start to look beyond traditional equity and fixed income allocation or the typical 60/40 portfolio construction by reallocating their assets into alternative non-correlated investment strategies with the ability to flush out cognitive investing biases through machine learning and/or behavioral arbitrage approaches, etc., deploying a systematic cross asset classes pursuit of alpha. In short, forecasting, and deductive reasoning of future outcomes (i.e., investing) is not rocket science; it is a discipline.