Component Tactical Asset Allocation: Part 3

This is the final of three posts on Tactical Asset Allocation. Part 1. Part 2.

The subject of this post is the theory of the market process and tactical asset allocation and why I believe that the former implies the latter will be a more successful strategy than buying and holding index funds.

The fundamental implication of the Efficient Markets hypothesis is that if information will be quickly incorporated in security prices. Mathematically this implies that stocks follow a random walk with jumps when new is absorbed by the market. Based on this assumption, the ideal investment strategy under the Capital Asset Pricing Model is to hold the market portfolio for the long-term (I know I’m ignoring Treynor-Black).

Beyond the typical objections to EMH, there are two main insights from the market process school that leads me to reject the EMH and I believe they are the most important observations of the school.

First, there are significant government interventions that make the market remarkably inefficient. The most important is the business cycle and monetary problems that in the 20^th century has almost always been caused by central banking. The standard Mises-Hayek theory of the business cycle is that by pushing the interest rates lower than the natural rate of interest, a central bank encourages investment beyond what would happen in the free market. Eventually the investment works its way into a boom for the producers of consumers’ goods and prices begin to increase. In order to stop the boom (to prevent runaway inflation), the central bank must raise rates. This action ends the boom and the process to correct the malinvestments made in the boom period. Since capital intensive industries are more exposed to interest rates, they typically feel more pain than consumers’ goods industries.

Moreover, governments intervene in other ways that are frequently not understood well enough by investors or they don’t always understand the implications. Economics is not a terribly difficult discipline and figuring out the implications of dumb government policies isn’t that difficult. If the government subsidizes ethanol production, farmers will use less land for the production of the typical agricultural products and those prices will have to rise. If there is a war in the Middle East, it is likely that oil (unless they have refineries in the country in question) and defense stocks will typically increase in value. Investors react in the short-term, but over the course of 6 months to a year or longer, these plays are still profitable. I’m not sure whether it is the uncertainty of these situations or that investors systemically do not think the government is as bad as it is (possible given the state of business school economics courses, also it is very difficult to quantitatively test), but investors do not react strongly enough.

Second, the market process school emphasizes the role of the entrepreneur in moving the market to equilibrium prices. EMH doesn’t care about why prices behave in certain ways, it merely attempts to model them. However, what is seen as a random walk are actually deliberate actions taken by entrepreneurs engaging in speculation and arbitrage. Entrepreneurs who have greater foresight will outperform those who don’t. Furthermore, the investing, particularly derivatives, are referred to as zero-sum games. The profits are zero-sum; however, ex ante, all of these trades are positive sum in terms of utility. These trades show ex post profits or losses depending on the skill in forecasting of the entrepreneur.

Finally, as Hayek notes, there’s no such thing as perfect knowledge, as is assumed by the actors in CAPM. Knowledge is dispersed throughout society and the purpose of the market is to organize that knowledge. Market prices reflect the knowledge of all market participants.

Combined these three factors make tactical asset allocation an attractive prospect. Since there are cycles that can be observed by students of the Austrian School, it makes little sense to buy and hold equities when there are lengthy periods of time where you can lose a significant sum of money. Also, not only is there a purpose to being an entrepreneur which is ignored in the EMH, but paying attention to what happens to prices can reveal knowledge about other market participants’ knowledge and opinions in the market. Michael Covel notes in his book about trend following that trend followers tend not to be in the business of predicting trends, they have imperfect knowledge and as a group they have no opinions on the market. However, if the market is going up, they would be more than happy to buy and vice versa to sell. The logic is essentially the same for TAA. Mr. Faber isn’t providing a service in predicting the market, he’s trying to improve on the buy and hold passive strategy by staying out of the market when market participants have a negative outlook. Nothing wrong with that.