Knowing the inflation and growth regime is critical for equity and bond investing

 

Picking stocks and bonds is a critical part of investing, yet make no mistake, the inflation and growth environment do matter. It is critical to know what is the macro regime. Now it is hard to say what is the current regime relative to past history since you are living in the current; nevertheless, if you can formulate a view on the current regime, you can provide meaningful policy tilts for the benefit of your overall portfolio. When inflation is high, avoid bonds. When growth is high, hold stocks. This does not have to be complex, but a regime view is critical. 

The dampened business cycle - Will this continue?

 

We present two charts: one showing the dampened business cycle and the second on current growth forecasts. First, we are in abnormal period based on the low percentage of the time in recession. The data clearly shows that the business cycle has been dampened, yet the post-GFC period has been extremely mild. The question is whether this is the new normal. Have we eliminated economic downside? That conclusion is unlikely which leads to our second chart.

The Atlanta Fed GDPNow forecast is showing a significant decline in growth for the first quarter. Interest rates are higher. The projected growth expectations have been lower albeit the Blue Chip consensus is still at 2+ percent. Nevertheless, policy and trade uncertainty are causing many businesses to turn conservative. The GDPNow estimates provide a strong warning sign that if current trends continue, we will have a recession sooner than when most think. 

The value of overnight trading

One of the more interesting anomalies is what we can call the overnight effect - the fact that most of the returns generated for the many stocks and indices occur between the close and open and not during normal trading hours between the open and close. This may seem obvious to many given that much of the important news about stocks is generated after the close and before the open. For example, most earnings announcements are made when the market is closed. Chart is from Elm Street. 

However, some have argued that this is a result of price manipulation, see Bruce Knuteson, who suggests that price pressure overnight leads to then declines during the day. This manipulation focuses on pushing prices higher during less liquid times and then offsetting the gains during the day. This is an interesting and compelling story and is consistent with the data; however, it is not clear who and how big is this activity. 

Surprisingly there has not been much research explaining this anomaly other than to document its existence. 

Sector size and equity bubbles

 

The FT provided an interesting bubble chart on the size of the IT sector relative to the US markets and the rest of the world. Of course, we have been following the size of the Mag 7 relative to the rest of the SPY over the last year, but the size of the IT sector versus the rest of the world is crazy and suggests that the market is overvalued and in a bubble. Just look at the difference in size for the IT sector between 2010 and 2025 with the rest of the world.

There we go again with that term - bubble. The term is thrown around yet saying that a market or stock is in a bubble does not provide any action plan for what to do. The IT is larger, but what is the appropriate size? IT is clearly more important to the world economy today than in 2010, yet should it be larger than the market cap of the UK, Japan, and China combined? IT is changing the world, but how should this be valued as discounted future cash flows. 

One can avoid these markets and stocks but there is a strong opportunity cost. You will miss the sizable move and be out of balance with a market weighted portfolio. If you are a passive index holder, you are riding the bubble, so if you want to avoid, you will have to drop these market-weighted indices. Shorting is an alternative, but the pain until a crash is high and no one knows when a crash will occur. So, is it just a game of watching?