Slicin N’ Dicin

Before we dive into coffee today, I must confess that I am addicted to food. To be honest, this is no new revelation but something I am reminded of every time I devour a wonderful meal. And to be fair, I am not addicted to just food in general, but food that is life-altering, change shaping (metaphorically), and spirit-lifting. Food that radically alters our not so great of a day into one where we feel plump-fully content. I find nothing more satisfying than channeling my inner Tony Bourdain as I venture to the local market for the right ingredients of my next edible masterpiece.

In full transparency, I have been contemplating on making the French classical dish Beef Bourguignon but have been held back by intimidation of the drastically diverse recipes I have found in numerous cookbooks. There are recipes that take over a day and require as many ingredients as there are screws to a piece of Ikea furniture, and some recipes that take half an hour and have fewer ingredients than a peanut butter jelly sandwich. The challenge of selecting the right recipe is painstakingly real because the last thing any self-proclaimed chef wants is a burnt ego from creating a meal that tastes no better than the day-old hot-dog at the local gas station. But during these moments, I recall what my father (an actual professional chef) used to tell me, “there are many ways to slice and dice a meal, just find the one that works best for you”.

During our coffee today, I am going to discuss that while there are many different ways and recipes for investment management, we use a certain recipe that helps remove the noise by reducing the complexities that best fit our style of analysis. So, grab your cup of coffee as we chat about our approach to investment management; leading economic indicators.

For the high-speed espresso drinkers, here is a quick bullet point synopsis:

  • Many ways to slice and dice investment management
  • Occam’s razor states that the simplest explanation is preferable to one more complex
  • Leading economic indicators are a reflection of asset pricing performance
  • Recovery in leading economic indicators underway will usher cyclical outperformance

Most investors and fellow practitioners know there is a tremendous amount of distraction in the financial markets. The complex and rapid dissemination of information requires market participants to discern what information is important to them and their investment goals. Our DelosCA investment strategy was designed with a structural process that adhered to a mental model known as Occam’s razor. Occam’s razor, in the purest form, states that the simplest explanation is preferable to one that is more complex. Our understanding and awareness of this mental mindset are not meant to oversimplify an incredibly challenging task, but to design an investment strategy process that is repeatable, adaptable, and remove unnecessary noise. Just like the plethora of recipes for Beef Bourguignon, there are many different methods of analysis for investment management.

The method of analysis employed by our firm is rooted in the belief that financial markets are acutely sensitive to changes in economic conditions. Therefore, we remove the necessary noise by focusing on a subset of data known as Leading Economic Indicators (LEIs for short). Per the Conference Board, an economic organization think tank, leading economic indicators are key components that signal peaks and troughs in the business cycle. Having a composite of multiple leading economic indicators helps deduce when shifts are occurring within the economy. By having a pulse on these economic shifts, we can construct portfolios accordingly. Below is a snapshot of the components represented in the Leading Economic Index Composite.

For full press release and technical notes: https://www.conference-board.org/data/bci.cfm?cid=1

As most of our readers know, we use the ISM PMI New Orders index, an LEI component, to assess the growth rates of economic conditions. In our previous coffee sessions, we discussed our DCA PIIL Model which aims to anticipate the direction of the ISM PMI New Orders Index. By assessing the growth rates of Policy, Interest Rates, Inflation, and Liquidity, we can probabilistically determine the growth rates in the LEIs. The chart below shows the strong empirical relationship between the ISM PMI New Orders Index, an LEI component, and the stock market and interest rates.

By assessing the direction of the LEIs via our DCA PIIL Model, we can properly construct investment portfolios that provide superior risk-adjusted returns. Our current assessment based on our DCA PIIL Model shows we are in the early stages of a cyclical recovery episode for the next 16 to 18 months which will usher a new era of cyclical leadership and portfolio positioning. The chart below shows the relationship between the relative performance of cyclical (dynamic) and defensive equities relative to the leading economic indicator, PMI.

While there are many ways to slice and dice one’s method of analysis in the investment landscape, we always find that investment managers that have a time-tested repeatable process are more likely to produce superior risk-adjusted returns. While many novice practitioners believe that the use of leading economic indicators are used to determine recession or when to sell stocks in favor of cash, we at DCA believe that is widely misguided. By employing a macroeconomic overlay, by the use of leading economic indicators, an investor can construct a portfolio with securities that bode well during the various growth rates of economic conditions. Per the chart below, the only way to have outperformed the S&P 500 was to be overweight the classical defensive sectors.

Please feel free to reach out with any questions, topic suggestions, or if you want to chat!

Sincerely,

ANDREW H. SMITH
Chief Investment Strategist
andrew@delosca.com
asmith971@bloomberg.net