One of the enduring insights of modern finance is that investment strategy is far more productive when focused on risk management rather than return. It's also clear from decades of research that the primary risk factor in the money game is the economic cycle. Connecting the dots, it's easy to see that even a small degree of insight into macro's ebb and flow can yield strategic benefits for managing asset allocation.
If you could muster the powers of prediction for just one variable, forecasting recessions and recovery would surely be at the top of the list for dispensing the proverbial silver bullet in money management for the long run. Risk premiums bounce around quite a bit and the No. 1 reason is that the economy cycles between growth and contraction. Turning this simple fact into above-average excess return would be a breeze if the future were clear. Oh well. Uncertainty shuts down that avenue of possibility. Or does it?
No one knows what the months and years ahead will bring, but that's not the same thing as saying that handicapping the future is worthless. In fact, developing perspective about tomorrow and beyond starts with one sturdy detail that's virtually assured: A new recession is waiting in the wings.
Recessions are a persistent lot. There have been 33 since 1857, according to the National Bureau of Economic Research, the official arbiter of turning points in the U.S. business cycle. It's a safe bet that number 34 is lurking in the future. "I devoutly hope our next downturn won't come for quite some time, but it surely will come eventually," Dallas Federal Reserve President Richard Fisher said in a recent speech.
Exactly what the next cycle brings, and when it arrives, keeps countless economic debates bubbling, of course. But the high confidence that accompanies the forecast that another downturn will arrive eventually is at the core of explaining why returns on risky assets will continue to bounce around.
"The basic theory of finance says that recessions are the fundamental risk that everyone worries about," says John Cochrane, professor of finance at the University of Chicago Booth School of Business. It's also clear that the recurring feature of falling prices during recessions is more than coincidence, he explains.
Macro Intelligence & Missed Opportunities
It's debatable how deeply investment strategy in the real world is conceived with due respect for the business cycle in general, or the outlook for the next recession in particular. What is clear is that minimizing, much less ignoring, macro's role for gaining perspective about expected returns is tantamount to dismissing a fair amount of useful information.
Studying the links between the capital markets and the business cycle isn't new, nor does it offer shortcuts for predicting return and risk. But research in this niche continues to deepen, offering a window of understanding into the crucial framework of asset pricing. Even better, the investment opportunities identified in this corner of finance aren't being arbitraged away quickly, if at all.
Why is so much constructive research about the markets and the economy routinely unexploited? It's common knowledge that fluctuations in risk premiums tend to exhibit what's known as mean reversion over time. High performance leads to the opposite, and something similar applies to the economic cycle. In other words, when you invest is just as important as the design and management of asset allocation. The close association of broad economic trends with excess returns is the reason. But even wide recognition of this link doesn't inspire timely adjustments in asset allocation as a general rule.
A number of studies show that investing habits in managing the asset mix are conspicuous mostly for the lack of action, particularly among individuals. "One of the major drivers of household portfolio allocation seems to be inertia," comments one report ("Do Wealth Fluctuations Generate Time-Varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," by Markus. Brunnermeier and Stefan Nagel, in the American Economic Review, June 2008).