It is all too easy to be the victim of Information Overload when preparing to make an investment decision. The term Information Overload was originally introduced by Alvin Toffler in his 1970 classic book, “Future Shock”. The ubiquitous Internet and the 24/7 news cycle have only reinforced this exacerbating and exhaustive circumstance.
The search to contain this epidemic has directed some folks to a more global macro approach to the investment puzzle. Whereas historically, significant effort was focused on individual stock selection, academic research and professional money managers are more likely today to concentrate on more macro-oriented analyses such as asset allocation judgments, category dynamics evaluations, and sector rotation assessments. The likelihood of more meaningful payoffs are enhanced, and, concurrently the required time commitment is reduced, with this broader lens policy.
Research has confirmed that the most reliable rewards are delivered from broad asset allocation decisions and not from rare, individual super-performer stock picking. Also, a more global approach that embraces wide diversification minimizes overall downside risk. Significant risk reduction (as measured by portfolio volatility) is achieved as investments flow from separate stock holdings to sector holdings to international marketplace assignments to a top-tier equity/fixed income mix decision tree.
How now to make these challenging and complex decisions?
One answer that is gaining popular professional acceptance because it is relatively simple to implement, and, at least attempts to avoid the Information Overload scenario, is to embrace a factor model. The fundamental concept is to make a buy/sell/hold decision on a pre-selected and limited number of dominating factors.
What are these factors and what market metrics are needed to assess them? Here are a few factors proposed by several market gurus who subscribe to the limited generic factor approach as applied to investment class groupings.
The two market professionals that I reference are Elaine Garzarelli of the 1987 market crash prescience fame and Jack Albin, chief investment guru from Harris Private Bank.
Jack Albin documented his global macro investment concept in a 2009 book titled “Reading Minds and Markets”. His basic methodology is to assemble a short list of fundamental, technical, and behavioral factors to drive the investment decision-making process. It’s a philosophy to tilt the odds just slightly. It emphasizes sector and category investment selections over specific stock/bond choices.
The Albin 5-factor model includes Valuations, Momentum, Economy, Liquidity, and Sentiment components. Of these 5 elements, Albin rates Valuation and Momentum at the highest level. He endorses the other three elements as more confirmatory in character. He will not consider the lower tiered criteria unless the dominant two are blinking the go-ahead, flashing Green-light signal.
Some of the metrics that measure the current state of the Valuation factor include elements such as the conventional Price to Earnings ratio, the Price to Cash Flow and the Price to Sales ratios (the usual suspects), and the famous Greenspan/Yardeni Fed Model that uses both the 10-year treasury and triple-B rated bond data for comparison purposes. The Momentum factor metrics include longer term moving averages criteria and market/sector breath indicators such as the advance/decline line, the number of highs to lows ratio, and the ARMs data sets.
For the Economy factor, Albin lists bond yield curve direction, the gap between corporate and government bonds, and the Conference Boards 10 leading indicator array as useful metric tools. He recognized that short term data exhibited too much noise to be reliable, so data collection periods often exceeded 9 months. Albin recommends monitoring the M2 money supply, yield spreads, and closed-end mutual fund money flows that impact premium/discount NAV numbers to gage Liquidity. Remember that Liquidity is the fuel that fires the business engine.
Albin acknowledges Market Psychology/Sentiment as the fifth factor. This was the last factor unit added both by Albin and by Garzarelli. Albin uses it as a confirmatory signal, not as a primary indicator. He identifies the AAII sentiment indicator, the VIX index, and short selling lists as contrarian signals.
Behavioral scholars have concluded that we are not totally rational investors. Fear and greed always enter into the investment equation. Therefore, none of these signals are without residual risk. Sometimes the herd is right; sometimes the wisdom of the crowd persists, but trigger points that generate bubbles ad panics exist.
Today, Garzarelli’s factor model incorporates 14 separate metrics in four generic categories. Her four generic categories are: Cyclical, Monetary, Value, and Market Sentiment units.
Her Cyclical grouping metric includes industrial production and corporate earnings metrics. The Monetary unit incorporates 7 separate metrics such as interest rate, yield curve shape, interest rate class gaps, and money supply that quantify monetary policy. The Value category features an earnings yield to interest rate ratio and a Price to Earnings equation.
The Sentiment array incorporates a mutual fund cash level metric and a composite of a bullish professional advisors strength metric. Her model influence coefficients (the weighting constants) are updated regularly, and these coefficients take both positive and negative (contrarian) values.
Note the similarity between many of the Albin and Garzrelli category factors and the metrics used to evaluate these broad indicators.
How effective have these global macro indicators been in defining tipping points and investment opportunities?
Their track record is surely imperfect, but many successes have been registered as well as some highly notorious public failures.
My purpose in submitting this posting is to encourage all Board members to consider a top-down investment approach. In at least a partial sense, we all currently deploy some form of the analyses type advocated. We purchase mutual funds and/or ETFs for the major portion of our portfolios. We typically eschew separate stock holdings. As a cohort, we tend to establish longer-term positions. The global macro investment approach seems to be an integral part of our investment DNA.
Simplifications in the investment process is a very desirable goal. But caution must be respected when putting this guiding principle into practice. Albert Einstein noted that "Everything must be made as simple as possible. But not simpler.”
Best Regards,
MJG
Comments
I completely concur with your well crafted comments. Good work.