Underpin the investment methodology with an empirical basis upon which the major global equity markets are each valued as a whole, and establish sound justification for the stance that follows. Worked here on Japan, live from the run currently published.
Ten years of month end closes, taken as published. No smoothing and no adjustment. Every figure on this page is output from the run currently live, not an illustration of one.
Inflation, employment conditions, money supply, real corporate interest rates and corporate profitability. Chosen for explanatory power, and then filtered by a harder test: each must be published on a comparable basis in every economy we model.
One regression across the window gives a model price for every month in it, based on the market's own historical relationship to its key economic drivers. Not a forecast. A statement of what the conditions of the time supported.
Month by month, what the model cannot account for is the gap between where the index traded and where its drivers put it.
The same instrument runs on 22 further markets and on the MSCI World: Switzerland, United States, Australia, France, United Kingdom, Canada, Italy, Germany, Portugal, Sweden, Netherlands, New Zealand, Norway, Ireland, Denmark, Spain, Singapore, Finland, Austria, Hong Kong, Israel, Belgium. Clients drive any of them.
The same five in every market, so that 23 results are comparable with one another. Availability decided more of this list than elegance did, and that is the correct order of priorities.
Moderate inflation is the key ingredient for a healthy economy. It is THE prevailing economic driver. If you can effectively manage inflation, you will have a robust, sustainable level of economic growth.
It is also a very, very hard thing to keep on track.
Imagine the economy as an old steam locomotive. The government uses all manner of fuels to power the locomotive, through interest rates, money supply, open market operations, changes to the tax regime and so on, and the cumulative effect is that a certain amount of economic coal is thrown into the furnace.
If they do not throw in enough coal, the train barely has the power to leave the station, and if it does it may soon stall again.
If they shovel on too much coal, it will certainly power out of the station, but it will also begin to accelerate to an unsafe speed, and at that point its own momentum may leave the engineer with no choice but to slam on the brakes. Just ask Paul Volcker.
Inflation seeps through the system. It starts in commodities, moves through the production system, and finally reaches the consumer's pocket.
Employment conditions are impactful throughout the economy, and there are several measures that could be used: the unemployment rate, average hourly earnings, the number of hours worked, initial and continuing unemployment claims.
For the purposes of the model the unemployment rate is chosen, as it is not only a solid predictor but is available for most markets in a timely fashion, thus enabling a consistent approach across diverse economies.
This is the economic equivalent of clean coal for our locomotive. It burns quickly and efficiently. There are several measures that could be chosen to evaluate it.
M1 is too narrow a measure to effectively gain an overall picture. M2 encapsulates those components of money supply with sufficient liquidity to have an immediate impact on the economic furnace, but is not available for all economies. M3 is a broad measure, is the most widely available, and is thus the best for comparisons.
This is a measure of the true cost of borrowing at the corporate level. In the past several deflators have been tested but, as with the other variables, the aim is not to curve fit the model. It is to allow it to be robust and applicable to all markets.
For this reason, a measure of the spread of corporate bonds over relevant government bonds is used.
This final measure is derived from other raw series. The rationale is that profits are sales less cost of sales.
The producer price index of finished goods and the consumer price index are the best representations of the prices businesses receive for their products, so an average of those two measures is taken. Commodity and manufacturing producer prices, being raw inputs, are the best indication of the cost of raw materials.
The market can stay irrational far longer than you can stay solvent.John Maynard Keynes
Which is the honest limit of this chapter. The market model gives a directional stance with an empirical basis, and it gives it monthly, so exposures can be reassessed as conditions change rather than when someone remembers to. It is a genuinely useful instrument for deciding where a global portfolio should be heavier and where it should be lighter.
And when the gap does close, it does not always close from the side people expect. While mean reversion is widely accepted, sometimes the mountain comes to Mohammed and the underlying macro environment is the line that moves. Oftentimes, both do. A model reading is an estimate drawn from historical relationships, not a forecast that the price must travel.
What it cannot do is carry the decision on its own. A market can sit above its model value for years. That is precisely why there are three more chapters, and why no allocation in this framework rests on one number.