Cocktail Economics: Shaken Not Stirred

A recent book addresses the need to get beyond the average.
Author:
Publish date:

Too many financial planners and advisers have investors believing that average and thus "passive" investing is good enough. To be sure, average is not bad at all, but it's not great, either.

Cocktail Economics

is interested in great.

Like the planners, too many investors have been lured into the belief that average gains are the best they can hope for. What if I told you there is a way to capture the upside of each economic cycle that will have you ahead of the pack for most of your investment life?

You might hesitate, thinking you were being sold a get-rich-quick scheme, which, assuredly, is not my plan. Rather, this book sets forth an intuitive approach to investing that takes into account all the macroeconomic forces that act on the performance of every possible asset class.

Here are the basics of why cocktail economics and its application to a cyclical asset-allocation strategy will put you at a competitive advantage to a great many investors:

  • First is the fact that market cycles both exist and are predictable. The economy, the direction of the stock and bond markets, and the emergence and disappearance of positive and negative shocks are interrelated forces. As these forces play on each other, market cycles emerge, whereby one asset class outperforms another. Because economic shocks, particularly those related to public policy, are foreseeable, and because we can judge how these shocks will act on asset classes and the economy based on like situations in the past, predicting cycles becomes a strong possibility. And because market cycles tend to last awhile, often for a few years or more, there is ample opportunity to act on them. Indeed, rather than dive into a new market cycle, you can wade in, taking action once a cycle has established and projects to stick around.
  • Second is the fact that not all investors, by a long shot, are going to invest and adjust their investments in relation to the predictable fluctuations in the broad asset classes. Lower-risk, long-term, passive-only investing will be around forever; the great herd of average investors will forever roam. And where there is average investing, there is an opening for above-average investing.
  • Third is the fact that timing is an essential element of a cyclical asset-allocation strategy, although you will still benefit if you correctly adjust your allocations after an economic cycle has established. That said, you want to activate your tilts early enough to capture as much of a cycle's upside as possible. This is not to say that investment forecasts based on a sound rendering of the macroeconomic environment will be correct every time; sometimes the forecasts will be off. It's just like the weather, an analogy I incorporate to describe the fundamentals of forecasting and timing. Sometimes it rains when the weatherman predicts sun, and other times it is sunny when the forecast calls for showers. But the farmer out in the field always has a hand up on the weatherman. When he sees black storm clouds on the horizon, he can make the safe assumption that bad weather is coming and pull his tractor into the barn. In doing so, he uses additional information to his advantage. Or, in the abstract, he has applied his educated rendering of the variables to his decision rules for when or when not to take action.

This information advantage applies to the investment strategy I'm setting forth. The better you get at it, the easier it will be for you to timely apply a macroeconomic analysis to your decision rules for when and how to adjust your investments. You want to stay as close to top-down information as possible, essentially becoming the farmer who watches the skies, not just the weatherman who looks at the radar.

In fact, it's preferable that you wear both these hats. If you wear the farmer's hat, you can see the storm clouds as they relate to these events, and you very well might be able to anticipate cyclical changes in the economy and the stock markets they will deliver. To improve this forecast, you want to put on your weatherman hat, collecting the forecasts of seasoned pros who can corroborate your opinions.

Indeed, don't get the feeling that you'll be left standing out in the field gazing into the sky, attempting to figure out the relationships between economic shocks and investing on your own. Throughout this book, I outline the precise conditions under which the exposure to the various classifications of stocks and/or bonds should be increased or decreased. Then, using historical data, I illustrate the potentially significant benefits of such a cycle-driven strategy.

These three facts present the opportunity for any investor to perform better than most. I provide in these pages a framework of filters that have proven over many years to accurately identify which asset classes will perform best (or worst, or neutral) in each economic environment. Can asset-class swings be predicted? Yes. Furthermore, as investors, can we time our actions to those swings? Yes again.

This might sound like powerful stuff, and it is. In my experience, any investor who faithfully applies such a program has little option but to perform better than the great many investors who do not.

Much

better.

I'd like to leave you with a very cocktail-economics way of thinking about the application of this strategy.

Question: How do you turn a martini into a Gibson?

Answer: You put an onion in it.

And if you'll allow the gin and vermouth in the glass to represent the sphere of economic forces, the onion in the glass can represent the range of investment decisions you can make based on your rendering of these forces.

Onions have layers, just like this multilayered investment plan. The first layer consists of building a benchmark allocation to the various asset classes. The second layer consists of an application of a macroeconomic forecast to one of four different pair-wise asset choices: large-cap vs. small-cap, domestic vs. international, value vs. growth and stocks vs. bonds. The third and final layer consists of deciding among the various active and passive strategies.

The result is a cyclical asset allocation that will have you best-positioned to take the most advantage of the stock and bond markets through every economic cycle.

Victor A. Canto is founder and chairman of La Jolla Economics, a leading economic consulting firm. He has served as managing director of the Cadinha Institutional Services asset management firm, a trustee of StockJungle.com, director, CIO, and portfolio manager of Calport Asset Management, and president and director of research of A.B. Laffer, V. A. Canto and Associates.