Raoul Pal: The business cycle time horizon is basically-- most business cycles, the up cycle tends to last between 4 and 8 years. We've just had the longest one ever. The down cycle tends to be 18 months to 3 and 1/2 years. OK, that's great. Now you what you're playing with. What you really want to do at a very simple level is buy risk assets at the bottom of the business cycle and hold them all the way.
So the easiest way is if the ISM crosses 50 on the way up for when it's properly formed an economic base-- I would argue that this current situation is not that, but I could be wrong-- you hold risk assets all the way through until it crosses back down to 50. And it's on his way back down again. You've got other indicators of recession. That basic asset allocation will keep you in the game.
Now, you can get cute, then, within that business cycle. Is the economy likely to expand or contract over the period of time you're looking at? So right now, I still think we're in the contraction phase. That contraction phase, I think, probably lasts another 18 months. Because that would be normal. So if I'm biased towards that, then it sets up certain biases within the portfolio. This is why I don't trade the short side of bonds, because my secular thesis is bond yields fall and my cyclical thesis is bond yields fall. So why would I trade against that? Because it doesn't fit my time horizon.
Somebody else has a shorter term time horizon would just say maybe-- and I'll come on to short-term time horizons later-- is that sentiment shifting and therefore I'll trade the sentiment. That's great, and it works for people. My way is not everybody's way, it's just how I do things and it's what's given me the success and the proven track record that I've had over the years is by doing this. And I've taught people at Goldman and the graduate program, this is how you-- this is how you look at markets, and this is how you analyze it. This is what you understand with the economy.
Because most people don't understand what to do with the economy. They see the data, and then want to trade the data. That's not what we do. The business cycle is all about understanding where it's going.
DARIUS: Nothing we do is easy, as you know. You're bolted to the chair like I am every day. But there are a few things in our market lives that they come around every three or four years that are pretty easy. Whenever you're at the peak of the sine curve for growth and/or inflation, there's some very obvious asset allocation pivots you need to make. You need to go high-grade your quality in terms of your credit exposure. You need to sort of high-grade your cap size, or capitalization with respect to your equity exposure. And you obviously need to start pivoting back into bonds in lieu of riskier assets, in lieu of commodities, in lieu of riskier equities, in lieu of things of that nature. And, oh, by the way, buy the dollar, buy gold.
Every single time you're at the peaks of those sine curves, it's a very obvious trade. But it's so hard to put it on in the moment, because in the moment, all the backward-looking data is telling you inflation is really hot and jumping through the roof. Growth momentum is picking back up and it's still extremely elevated. Consumer balance sheets are very fine and have all this excess savings. And so the narrative machine out there-- and I think is as big as it's ever been, if anything-- the biggest bubble I see out there is the bubble in narratives.
Maggie Lake: The one thing that both Darius and Raoul have in common is that they both have very clear frameworks. This provides the starting point from which they can begin to analyze markets and spot trends as they develop. Both of them acknowledge some truths about the business cycle and the appropriate asset allocation around inflection points. Risk assets, like equities, tend to benefit as the cycle bottoms. When the cycle tops, Darius highlights some improvements to the asset allocation by focusing on larger stocks, higher quality bonds, gold, and the US dollar. We'll talk more about appropriate asset allocation across the full cycle in the coming workshop.
Another important point, the more you look at the business cycle, the more you'll start hearing the word liquidity, or alternatively, financial conditions. This is a very, very important variable in this puzzle. Let's hear Jim Carson and Julian Brigden talk about its relevance.
SPEAKER 3: But that said, I'll start with the basic kind of-- when the Fed reduces liquidity, it does four major things that are bad for markets. So the market gets hit in a lot of different ways, and assets broadly. One, it just reduces asset demand, right? It's buying less assets. It's also giving lower, less liquidity to companies who are ultimately buying other assets or buying their own, buying back their stock, right? Whether it's leveraged buyouts as well, there's all kinds of needs of which the demand for assets decreases.
Two, raises interest rates, which ultimately creates a TINA effect, right? So not only broad asset demand lower, but the demand for stocks decreases because there is no longer-- there is no alternative, right? You can have an increasing alternative of higher rates and other assets to put your money. So that's two. Three, the discount rate for companies to invest in new net present value, kind of a creative things to their portfolio gets worse. So on a fundamental basis, which is the thing people most think about, I think it's not the first or second, maybe the third most important thing out there. But that has a real effect underlying longer term as well.
And then four, and this is the part that we're more experts on, I think is actually very, very important-- is that it increases risk premium. It increases volatility in the system. So on a risk-adjusted basis, buying equities as a horse gets worse and worse. There's a lot of strategies that look at vol, though, targeting. I can go on and on about how important vol is in investment and decisions quantitatively. It's quite simply a basic form. Risk-adjusted returns get worse, so equity demand increases-- decreases that way as well.
So really, four different pathways all really kind of left hook, right jab, right tougher-- tough for that market, for a market to deal with that kind of reduction. And so all this momentum-- and this is why bubbles happen despite us all knowing that it's happening, right? When monetary policy is that strong, it's a virtuous cycle. And when it gets withdrawn, and it's quite the opposite.
And they're overlooking the fundamental tool that policymakers use to control the economy, and that is actually financial conditions. They have two instruments they can use to affect those, and those are interest rates, and these days, the balance sheet. But those in themselves have utterly no bearing on things. I mean, we do not care, which is what Fed funds are, what a bank earns in the overnight decorate. It has literally no relevance to anything that we do in the economy. What we care about is what happens to our mortgage rates, and that's basically a function of 7-year bond yields, let's call them 10, OK?
What we pay for a car loan, let's call that-- well, these days, actually, also almost a 7-year bond yield because Americans take credit out for so long to own a car. But let's say two. What we care about is our wealth, and that's a function of what the equity market is basically doing. What we care about is where we can borrow money as a company, and that's really what credit spreads are doing. And then what it costs us to import something or go on holiday abroad or so on and so forth. That's the dollar.
So these five metrics, some sort of metric of short-term interest rates, long-term interest rates, credit, costs, the dollar, and the equity market, those are what are described as financial conditions. And there's various financial conditions-- metrics-- that you can look at. The Chicago Fed produces one, Goldman Sachs produces one. And that is how-- and this was explained by Jay Powell just the other day-- he said, "This is how we influence the economies, through financial conditions."
Because it can't just be about Fed funds. To use that old adage, if the tree falls in the woods, OK, no one hears it, did it fall? So if Fed funds go up, and two-year rates don't respond, and 10-year rates don't respond, and credit doesn't respond, and equities don't respond, and the dollar doesn't respond, did you tighten financial conditions? Did the tree fall? And this is what I think people don't understand.
So I think it's a concept that people really, really need to understand. It is that the way central banks-- particularly in the United States where we have a very, very sensitivity to equities because that's where we put most of our net worth-- that's quite different from other countries who were very bond-orientated to savers.
You have to look at financial conditions. This that will be determined what ultimately policymakers do when they stop tightening, when they start tightening. And up until now, we've had this bizarre situation that financial conditions have barely tightened 1% off a 40-year low, despite the fact that bond yields just keep rising, rising, rising. Because we're really not hearing it-- maybe that's changed in the last 24 hours, 48 hours-- but we're really not hearing it in the equity market in particular.
Maggie Lake: Liquidity is one of the most important variables that professional investors follow. As Julian explains, it drives most of the economy, and is a crucial driver of the cyclical trend. We'll talk more about it in the coming workshop, so mark it down. And lastly, moving on to the final time horizon for market drivers, let's look at how a tactical opportunistic trader like Tony Greer navigates these markets.
DARIUS: I think they go one, check out the economy, which will be slowing, by the way, and then have to just wait until 2023 or 2024 to really pick back up.
Tony Greer: I could absolutely accept that. That makes a lot of sense to me.
DARIUS: What are your thoughts on that? Am I out to lunch there?
Tony Greer: No, I kind of listen to you, Darius. The Fed, for me, is just another window on my dashboard to keep an eye on. I listen to your economic predictions, and I listen to what people think about the Fed. I'm a reactionary trader. So I'm not even capable of coming up with theses of how many rate hikes we're going to have over what period of time. It's just not how my brain works, right? So I look at my method of watching the Fed is watching the Fed balance sheet. And I find-- I found it was very interesting to see that we're talking about tapering and we're talking about potentially tightening in order to combat this inflation.
And you say, oh, really. And you look over the Fed balance sheet and you say we've added $1.7 trillion this year.
DARIUS: Oh, yeah.
Tony Greer: They show-- it shows no sign of backing off if you look at the chart on Bloomberg. So that's my guide as to you've got a mechanism of your own of what is driving markets now. And for me, that's a big part of the mechanism that's driving the equity market. So that's kind of how I'm looking at that. Do I believe that they're going to have to make adjustments and address this clear headline inflation? Yeah, and I'm kind of just going with your idea of how they do that. That totally can make sense to me.
So, and like I said, only because I'm not in the business of making predictions like that, that sounds like a great niche for 42 Macro, because it sounds like a very well thought-out and constructed theory.
DARIUS: Yeah, no.
Maggie Lake: So we've heard some diverse perspectives from a variety of investors who look at things through a different lens, but they all have one thing in common, and that's an approach and a framework. You might favor Raoul's style and prefer to look at things over months and years and watch for indications of changes when building your portfolio. Or you may be a little bit more like Tony Greer, and be aware of longer-term trends, but also be very clear that you are a short-term trader, something you should not lose sight of either.
Remember, though, as we saw in part one when we talked about your game, Tony also has a longer-term portfolio. Mixing approaches is also fine. So that's it for now, but before we go, let's just recap what we've learned. Firstly, even the best in the business recognize that market drivers have different time horizons and that they must respect these. But no matter what their time horizons are, they have a base case or a framework to work from and remain aware of the other drivers that influence things, even if they're not trading over that particular horizon themselves. Next, let's dive deeper into all of these concepts and break them further apart with Roger's help.