(Bloomberg Opinion) — The financial markets operate within a series of market regimes during which certain sets of economic conditions exist for a period of time.
My first encounter with the concept was in 2000, when I read quantitative analyst Emanuel Derman’s paper, “Regimes of Volatility.” Derman explained that we have periods with persistently low volatility and periods with persistently high volatility. But this is also true of other market variables such as inflation, interest rates and commodity prices. Market regimes can persist for many years, but investors often fail to adapt.
Take the events of earlier this year. Some investors benefited when inflation rates began to rise and bond yields shot up after Joe Biden’s presidential inauguration in January on speculation that increased government spending and bigger budget deficits would soon follow. Other investors were poorly positioned for this regime change and fought against it, losing money in the process. But those latter people are now being rewarded, as 10-year yields have dropped and the old disinflation trades make a comeback.
The point here is not who was right or wrong, but that the goal of an investor should be regime agnostic — to be able to adapt and make money in all kinds of market conditions. It sounds easy enough, but the problem is that most investors are very rigid about their investing philosophy, which makes them poorly adapted to changing regimes.
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That’s because their investing philosophy is often tied up in their identity. They say, “I am a value investor,” and then they do all the things that value investors do, and wear all the same clothes that value investors wear, and drive the same cars that value investors drive, only to find their strategy out of favor for a decade or more. Why not just do what works?
I’ve spent about 10 years on Twitter, mostly as a passive observer rather than an active participant. And the one thing I’ve noticed over time is that some financial beliefs tend to correspond to certain political beliefs. For example, economics is explicitly political in that people on the right tend to believe in the Austrian school of economics and Monetarism, and people on the left tend to believe in Keynesian economics and Modern Monetary Theory.
This is easy to understand. Liberals tend to like Keynes because they believe in the power of government and the central bank to spend money and expand credit to achieve certain economic outcomes. Conservatives believe the government is powerless to effect positive change in the economy and think that interventions in the free market cause adverse unintended consequences.
But if you go back to 2017-2018, we were having arguments about something that wasn’t overtly connected to politics: index funds and passive investing in general.
Vanguard had just crossed $5 trillion in assets, and 50% of all assets under management were in passive funds. Yet, again, your view on index funds was probably determined by your politics. Liberals liked indexing because they believed in efficient markets and the pessimistic view that no one person could consistently outperform the index; conservatives believed that you could and you should try.
A more contemporary example is inflation. Those on the political right seem to think that we are going to get lots of inflation, while those on the left believe that the inflation is transitory and will return to normal. The conservatives, who are skeptical of government and central banks, blame the Federal Reserve, fiscal stimulus and unemployment checks for rising prices. Liberals hold the Fed harmless and believe inflation is due to disruptions in the supply chain and will abate.
No matter what issue you examine in finance, it’s the same people on the same side arguing about the same things. Liberals buy growth stocks and conservatives buy value stocks. Liberals think interest rates will go down and conservatives think interest rates will go up. Liberals like environmental, social and governance investing and conservatives deplore ESG. Liberals like technology stocks, and conservatives like energy and materials. Liberals like share buybacks, and conservatives like dividends. Liberals like fiat currency, while conservatives like gold or Bitcoin.
It’s important to note that these are broad generalizations, and there are exceptions to every rule. But when you see people arguing about finance on Twitter and elsewhere, they’re really arguing about politics. And people can be impolite when arguing about politics.
Interestingly, from 2010-2020, one might have gotten the impression that liberals were winning the argument. Growth stocks had an epic bull run, disinflation reigned, interest rates dropped, ESG trades were working and index funds were annihilating their actively managed counterparts. Since the pandemic, the trend has reversed and value has staged a comeback. What’s more, inflation is high and rising (as are interest rates), anti-ESG stocks have been outperforming, and nobody talks about indexing or Vanguard because they’re too busy trading on Robinhood. Of course, over the last couple of months, everything switched again.
I wonder if we’re not just seeing regimes in factors, but regimes in ideology. That is the essence of markets: Your side gets to win for a while, then my side gets to win for a while. But now these factors have political overtones. Could it be that finance is a battle of competing ideologies and that one side will prevail in the end? It sure seems that way if you talk to some of the gold bugs.
I tend not to view investing as an epic collision between good and evil. If you do, you are setting yourself up for failure because it causes you to think of those on the other side of the trade as adversaries rather than as someone with a different opinion. If you start believing that you’re a freedom fighter, it makes it very difficult to abandon positions once they move against you.