Welcome to the River FOURcast. The River FOURcast is our version of a weather forecast, providing us with a guide to the conditions we think are most likely for investment markets over the next 12-18 months.
The River FOURcast model breaks the investment markets into four distinct phases, and each of these is associated with different probabilities for investment returns. There are three primary inputs into the model that help us to determine what phase we are in. While no model is perfect, we find the River FOURcast to be a useful tool for portfolio allocation decisions.
Below, we explain the three primary inputs as well as what to expect in each phase.
Credit makes the world go round –or at least the economic world. Generally speaking, lower prices for credit – lower interest rates – increases economic activity in the near term. Individuals and companies are able to borrow to consume or invest when interest rates go down versus up.
We monitor credit conditions by tracking interest rates on various corporate bonds of both short and long maturity. We measure how these rates change versus their recent history. The absolute level of rates is not important for this measurement.
Although it takes time for changes in interest rates to feed into the wider economy, we believe that investment markets move quite quickly after credit conditions change as market participants anticipate the impact on the real economy. The Credit Conditions indicator is most useful for input into the one of our shorter-term signals on the health of the economy.
A healthy economy generally also means that companies are generating good returns for investors, supporting equity and corporate debt prices.
The PMI, or Purchasing Managers Index, is a good leading indicator of the future direction of an economy, and specifically future Gross Domestic Product (GDP) growth figures. The PMI uses survey data that covers current business conditions using metrics such as new orders, inventory levels, production, supplier deliveries and employment.
Investment markets, and equity markets in particular, are sensitive to the future path of GDP growth. PMIs are leading indicators and we observe a lag of about six months from a stronger PMI reading, for example, to stronger GDP growth. Equity markets also lead GDP and equity markets tend to react concurrently with PMI data.
Given this relationship, being able to predict future PMI levels gives some ability to also predict future equity prices. Our Economic Expectations indicator helps us to do this and is most useful over a 3-6 month horizon. The indicator provides an indication as to whether PMIs will be rising or falling, and like with Credit Conditions it is the direction of travel that is most important to markets, not the absolute level.
Our third market conditions indicator is our proprietary measure of equity market Valuation. Valuation is a somewhat obvious input into an investment process, but we also find that traditional market valuation metrics, such as the price-to-earnings or P/E ratio, miss a lot of important information. P/E ratios can be low, indicating equities are “cheap” or high indicating “expensive” for good reasons.
Therefore, we adjust valuations for the prevailing economic backdrop to provide greater predictive power.
Our Valuation metric tends to work best when looking over longer horizons, approximately 1-3 years.
There are nuances and interpretations with each of the input factors and we are constantly stressing the relationships and considering ways to improve our models.
As you can see, there are nuances and interpretations in each of the input factors and we are constantly stressing the relationships and considering ways to improve our analysis of each of the influences. But, we do think the three pillars will stay fairly stable as the inputs driving the River FOURcast.
The Four Phases Explained
Perhaps the most obvious phase to name is when valuations look cheap and credit conditions and economic conditions are improving. This is the time to be fully invested. This usually occurs after a large drawdown in markets, where investors were fearful and hence caused valuations to fall “too far”.
Generally, this is a once in a decade opportunity with anywhere from 50-70% of the market cycle’s returns being delivered during this phase. Here, we don’t need to be too clever about what we invest in, just make sure your portfolio is exposed to capture the market rally.
Downturn signifies economic and market conditions (declining credit conditions, declining economic expectations, expensive valuations) that lead in our view to a high probability of equity market falls.
By design, the River FOURcast usually transitions to Downturn several months before meaningful market falls, which affords some opportunity to plan for such an outcome.
This phase is characterized by supportive credit and/or economic conditions, but relatively expensive valuations. This phase has a higher probability than average of positive equity market returns, and historically it has produced the second-strongest returns after Upward Re-Rating. Many investors miss lots of equity market upside in the Apprehension phase because they are over-focused on valuations as a metric.
The Stable phase is characterized by supportive economic and credit conditions and fair equity market valuations.
Usually, we move through Stable between the other phases – particularly when moving out of Downturn. Stable is a time to be invested as markets tend to be positive and with relatively muted volatility.
Despite the attractive simplicity, the phases rarely follow in a specific order and it’s possible to skip a phase or even move backwards.
“History doesn’t repeat itself but it often rhymes”, as Mark Twain is often reputed to have said.
The River FOURcast doesn’t tell you where to invest as each phase will be different – it is up to human judgement to say how to use this model for investing. We are constantly learning and adapting as markets and the technology to study them develop.
Our Recent FOURcasts
Against a backdrop of weak credit conditions, expensive valuations and volatile economic expectations, we remain in the Downturn phase. As some countries begin to re-open there are early signs of economic improvements and the overwhelming policy response cannot be overlooked. The situation remains fragile as demonstrated by a recent surge in US cases. We continue to advocate exposure to high quality assets, as well as areas of the market supported by policy.
We believe we are still in the Downturn phase, but vigilance is required using this framework in these unprecedented times. Current economic damage is likely to have a material, lasting impact, as unemployment climbs and corporate restructuring becomes commonplace. But the significant policy response is a positive force on markets and cannot be overlooked.
We believe we are still in the Downturn phase of the market, but recognize vigilance is required when using this framework in these unprecedented times. The economic damage taking place has direct implications for future recovery. Eventual levels of unemployment, financial leverage, investment spending and consumer confidence will determine how quickly economies can recover.