David Ranson provided an enlightening presentation during the second part of CFA Society Chicago’s new Vault Series held on March 15 in the Vault Room of 33 N. LaSalle. Ranson is President and Director of Research at HCWE & Co., an independent investment research firm that was formerly a division of H.C. Wainright & Co. Ranson presented a simple, but effective model–based on his extensive research into capital market returns and correlations–that his firm uses to advise clients on tactical asset allocation. Their process uses historical market price movements to uncover predictive relationships between leading indicators and, highly-correlated, consistent outcomes.
The model’s simplicity derives from viewing the investment universe as comprising just four primary asset classes (exhibit 1):
- Domestic bonds
- Domestic equities
- Foreign assets and physical assets (commodities, real estate, etc.)
(It’s important to note that the model considers gold as uniquely different from all other commodities.)
Ranson began by describing the role of capital migration in investment performance (exhibit 2). Capital migrates away from countries or markets characterized by economic stagnation, lower asset returns, declining new investment, and rising unemployment, and will flow to areas where the opposite conditions apply. Causes of the poor performance can be excessive government spending, taxation, and regulation, and “regime uncertainty” stemming from secretive or unpredictable policies. These are difficult to quantify, but are usually accompanied by two more easily measured indicators: currency weakness, and rising economic anxiety (i.e., market stress). These two indicators are the primary market signals the model relies on. The price of gold serves to measure a currency’s value, and credit spreads measure economic anxiety.
Ranson described four economic scenarios arrayed in quadrants defined by the change in the rates of economic growth and inflation (exhibit 3). Accelerating growth occupies the two lower quadrants and declining growth the top two, while accelerating inflation resides in the two right-hand quadrants and decelerating inflation on the left side. The scenarios (quadrants) determine the best performing assets. Haven assets (bonds and gold) do best in the two upper scenarios when economic growth declines. Risk assets (equities and commodities) stand out in the lower half of the array when economies accelerate. When viewed laterally, financial assets (Ranson called them “soft” assets) that struggle against inflation reside on the left side of the array and those that do better against rising inflation (“hard” assets) reside on the right side. Hard assets include gold, other commodities, real estate, and foreign equities. (All foreign equities fit into this category because the model assumes they would perform comparatively well when an investor’s home currency is weak.) Putting the model together, shows gold as the preferred asset in the upper right quadrant (decelerating growth with rising inflation) and bonds preferred in the upper left quadrant (both growth and inflation decelerating). Domestic equities shine in the lower left quadrant (rising growth and decelerating inflation) while commodities and real estate are best in the lower right quadrant when both growth and inflation rise.
Ranson presented statistics to support his model (exhibit 4). Separating the past 45 years of available data for the United States, he showed that when the rate of GDP growth accelerated from the prior year, the returns on equities and commodities always improved, while returns on treasury bonds and gold worsened. When the rate of GDP growth slowed from the prior year, the reverse relationships held: returns on equities and commodities fell, and those for bonds and gold improved.
Looking at inflation rates revealed similarly intuitive results (exhibit 6). When the CPI accelerated in a year, financial assets (both stocks and bonds) exhibited weaker returns, and gold and commodities did better than in the prior year. When the CPI decelerated, financial assets enjoyed improved returns, while gold and commodities worsened.
Putting it all together (exhibit 11), Ranson presented an Asset-Allocation Compass with north pointing to heightened business risk, increasing investment anxiety, weakening economic growth and widening credit spreads. South points to the exact opposite conditions. East points to a weakening, or unstable, currency (measured by the price of gold) and west to a strengthening currency. He then filled in the best asset classes for eight points around the compass. His four primary asset classes occupied the diagonal compass points, corresponding to their positioning in the quadrant array:
- Gold in the northeast
- High quality bonds in the northwest
- Domestic equities in the southwest
- Hard assets in the southeast
Ranson assigned the primary points of the compass to sub-groups of the primary classes. The most intuitive one was Treasury Inflation Protected Securities (TIPS) pointing west (declining inflation, strengthening currency). Pointing south toward strengthening growth were risk assets: B-rated junk bonds, MLPs, and developed market foreign equities. Pointing east (rising inflation and a falling currency) were commercial real estate and C-rated junk bonds, assets exhibiting little influence from changing spreads and more from the price of gold. The distinction between B and C-rated junk bonds may be surprising but Ranson’s research has shown that while they are correlated to each other, C’s are much better correlated to the gold price while B’s correlate more to credit spreads.
The compass had nothing listed for north (weakening growth and heightened risk perceptions). Ranson noted that he was not aware of an asset class that would fit well in this slot but, like a gap in the periodic table of the elements, he could describe the attributes he expected it to exhibit. It would have to respond positively to widening credit spreads, and be little effected by the price of gold (or value of the dollar).
In response to a question following his presentation, Ranson pointed out that the correlations his model depends on often take several years to manifest themselves, so the model works best for patient investors with very long investment horizons.