#writing **December 4, 2023** _Why macro has dominated bottom-up investing for the past 20+ years and what it means when it is the primary factor driving returns. Utilizing cross-asset correlations to measure market sentiment and positioning._ _Why macro has dominated bottom-up investing for the past 20+ years and how to measure real money sentiment from cross-asset correlations._ Refs: @dailydirtnap Points: - Easy money has inspired the advent of factor investing, the death of active management, and the macro blob - Continuing our investigation of the growing irrelevance of the 60/40 portfolio due to falling correlation between stocks and yields - How easy money and tight money impact cross asset correlations - Dollar and yields tend to move together making the dollar stock relationship important: - Dollar rallies on FTQ - Dollar rallies as US increasingly dominates innovation - Stocks negative relationship to dollar and yields - Yield Curve's falling relationship to Stocks as stock yield correlation collapses puts stocks at risk Links: - [[Growth Inflation Tradeoff]] --- Jared Dillian recently observed that everything in the markets seems to be tied to the dollar: large caps, tech, rates, and the dollar are all the same trade and on the other side of that trade is gold, the yield curve, and small caps. The dollar rallied over the summer as rates rose and large cap tech stocks rallied on the back of the AI boom. After rates peaked in October the dollar has dropped which has benefited gold, steepened the yield curve, and helped small caps. He refers to this as the “macro blob” and while its existence confounds portfolio managers and asset allocators in can provide valuable information about market sentiment and positioning. There are two types of investors: top-down and bottom-up. The classic growth or value stock pickers are the bottom-up type investors and the ones who talk about rates, FX, volatility, technicals, etc. are the top-down types. While investors tend to group themselves into one of these categories, the determinants of market returns vary over time between top-down and bottom-up concerns. Central banks have always been an important top-down variable in the markets, but their prominence has grown exponentially since the GFC as they have grown their balance sheets via open market purchases of securities (chart below). Their influence has served to keep top-down concerns as the primary driver of market returns since the GFC and the asset management industry has responded with a proliferation of top-down product offerings with the widely chronicled death of active management serving as the primary evidence of this trend. As the macro blob dominates there is no reason to pay high fees for stock picking. ![[Pasted image 20231204150249.png]] Efficient portfolio construction is dependent on cross-asset correlations and optimal portfolios require an assumption about these correlations. The problem with this approach is that these correlations are not static. We have been covering how the 60/40 portfolio is becoming increasingly irrelevant in today’s world and the main reason for this is the change in the correlation between stocks and bonds. Portfolio managers are always looking to add things to their portfolios that they think will increase in value AND be uncorrelated to the rest of their portfolio. If they can’t get both they hope that adding something with a negative correlation to their portfolio will at least act as a [“hedge.”](https://publish.obsidian.md/cedarshillgroup/Portfolio+Management/Hedging) By observing how correlations change we can learn about the underlying flows in the market from real money investors as they shift the composition of their portfolios. We can see how short-term, “fast money” investors tend to play for recent correlations to continue, and whether they are reinforced by real money or if they are faded which indicates a larger allocation change is underway. When the stock-yield correlation is positive (i.e. negative stock-bond price correlation), trust in the central bank is high and monetary policy tends to be easy; when it is negative trust is low and monetary policy tends to be tight. This results not only from policymakers’ actions but also the market’s expectation of their policies. Higher growth typically leads to higher inflation but if the central bank can raise rates to slow growth and to prevent inflation then you tend to see a positive correlation between stocks and yields. However, high and rising inflation increases economic volatility and uncertainty, which makes the central bank’s job more difficult, which lowers trust, and during these times we experience a negative correlation between stocks and yields as the central bank is unable to change policy to influence growth or inflation. ![[Pasted image 20231204153940.png]] The relationship between the dollar and yields tends to be more consistently positive, which gives greater meaning to the correlation between the dollar and stocks. During 2022 stocks were driven lower by interest rates which also drove the dollar higher, resulting in a negative correlation between stocks and the dollar. After stocks bottomed out in October 2022 the correlation trended higher as the dollar sold off, stocks moved sideways, and the market attempted to re-establish the historical stocks and yields correlation. That attempt proved to be short-lived as stocks continued to decouple from the dollar and yields after the banking panic earlier this year. In the charts below see a pattern of knee-jerk reactions during short-term panics but then a return towards a falling correlation between stocks, yields, and the dollar. ![[Pasted image 20231204151413.png]] ![[Pasted image 20231204154823.png]] The breakout higher in interest rates over the summer was not accompanied by an increasing correlation between yields and the dollar. This was an indication that the increase in rates was not durable because it was attracting capital flows which were increasingly going into the bond market. Now rates have reversed, and we have not seen any change in the correlation which indicates that selling in the dollar is not taking flows away from the bond market. ![[Pasted image 20231204195540.png]] This past Friday we saw an attempted breakout in gold above the August 2020 all-time high. This is happening primarily because of the weaker dollar. Gold moves opposite the dollar and that correlation has remained persistently negative except for the flight-to-quality periods we experienced around the invasion of Ukraine and the regional bank panic. The rally in gold would be more durable if it could decouple from the dollar because the dollar is tied to yields and as long as both correlations remain in place gold will move in line with monetary policy. The gold bugs are constantly discouraged by this because gold is viewed as a hedge against easy money central banking policies. The ultimate dream for gold bugs would be to see the correlation between the dollar and yields drop at the same time as the correlation between gold and the dollar decreases. This scenario is typically associated with a balance of payments crisis where capital flees the US and goes into gold. That remains only a small probability now. ![[Pasted image 20231201145330.png]] The recent moves lower in the dollar and rates have propelled stocks and gold higher in a Pavlovian response to lower interest rates after years of rising interest rates. Our examination of the macro blob reveals that there is little let up in the trend towards a negative correlation between stocks and yields. Stocks’ relationships between the dollar and yields are both declining and negative as the lower dollar is not discouraging flows into either stocks or bonds. The last time the dollar sold off materially stocks were ~30% lower from current levels which allowed the lower dollar to be supportive for stocks. If the yield curve were to steepen lower short rates could keep pressure on the dollar while higher long rates could put pressure on stocks keeping in line with the prevailing negative correlation between stocks and yields. The correlation between the yield curve and stocks has moved into negative territory as the general stock and yield relationship has moved into negative territory as well. For stocks to continue to benefit from lower rates we will need to see a parallel move lower in rates, otherwise stocks could fall under pressure as the curve steepens. ![[Pasted image 20231204220844.png]]