Most research firms focus on just one of the three most critical forces impacting asset prices for their research offerings. We not only analyze all three Gravities individually, but we understand how the Fundamental, Quantitative and Behavioral Gravities work together to impact asset prices over different time frames. This three-dimensional view of financial markets allows us to consistently catch macro moves before the majority of other market participants.
The Fundamental Gravity
There are two chief variables that impact the direction of asset prices: one is economic conditions, and the other is how central banks respond to those conditions. Together, they drive what we call an economy’s Fundamental Gravity.
We anchor every market bias we carry to its Fundamental Gravity. At any time, an economy can be in one of four different Fundamental Gravities. Each Fundamental Gravity impacts the risk and return of asset classes in a very specific way.
But don’t just take our word about the keen insight that Fundamental Gravity gives us when it comes to how the asset classes trading in a particular economy should be behaving: the data backs our perspective. The following example shows just how impactful the Fundamental Gravity is to the risk and reward of asset classes in the U.S.
The illustration above shows just how important it is to be aligned with the Fundamental Gravity. The chart above shows the performance of several US sectors, and asset classes, during various economic conditions. Many investors believe asset classes have inherent reward-to-risk characteristics, like Treasuries are "safer" than stocks and utility stocks are "safer" than technology companies. The reality is that the risk and returns of asset classes, varies depending on the prevailing economic conditions. Above you can clearly see the asset classes that many consider to be "safe" experienced lower relative performance, coupled with maximum drawdowns three times worse than the assets investors consider to more "risky." Aligning yourself with a market or company's Fundamental Gravity allows you to side step possible risks and position yourself in the asset classes that might experience higher returns and lower downside risk.
The Behavioral Gravity
The behavioral aspects of financial markets are just as important as the fundamental and quantitative because human beings are innately flawed decision makers. Remember, markets are driven by human beings making human errors, which is what gives rise to risks and opportunities.
The Behavioral Gravity helps us to quantify investors’ current perception of a market (or company) and how their perception is changing over time. We don’t have to guess what’s going on in their heads, because their investing behavior tells the story.
The chart above shows our Behavioral Gravity Index, which helps us monitor market particpants' bias of a particular market. We consider any reading above 50 to be an extreme and consensus bullish bias. We consider any reading less than -50 to be an extreme and consensus bearish bias. You can see from the chart above, which goes back a little over a year, how investors' perception of these three markets have changed as we moved through time.
The Quantitative gravity
Human beings are innately flawed decision makers, and this humanness is on full display when investors attempt to evaluate the quantitative aspects of financial markets.
We are hardwired to obsess over the smooth and symmetric, which is why we look for patterns and symmetry everywhere. This subconscious obsession forces us to impose patterns where none exist, and to deny patterns if they don’t conform to our perspective.
Our DNA is why “technical analysis” is fool’s gold. Investors identify various chart pattern formations, or “support” and “resistance” levels simply by eyeballing a chart. Most people don’t understand that chance alone creates false patterns and cycles that appear to be predictive, when in fact they are not.
To be clear, our Quantitative Gravity framework is not “technical analysis.” You’ll never hear us discuss head and shoulders patterns, abandoned babies, or other indicators with no value at all, like the MACD. Instead, we harness the power of Chaos Theory to more accurately quantify the underlying dynamics of market structure.
Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price. Price is the messenger, not the message; to glean valuable quantitative insights about financial markets, we must look well beyond price.
Specifically, we’ve identified the four main quantitative dimensions of financial markets that affect price movement: social energy (trend), force (momentum), rate of force (buying pressure), and volatility.
This Quantitative Gravity framework is designed to help us determine when markets are moving from one state of rest to the next. More importantly, the framework is designed to make sure that if there is no advantage to be had in the current market structure, we do nothing.
Bringing it all together
For us, the very best opportunities come when investors perception of a market diverges from that market’s Fundamental Gravity. These opportunities most often present themselves when a market’s Fundamental Gravity undergoes a shift from bullish or bearish to the other side…because investors are typically slow to recognize those shifts.
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