Having detailed the three main approaches to investment management in an earlier article, I would like to take an in-depth look at macro investing. Macro investing relies on developing broad market views, determining which securities will benefit from these views, and building a portfolio based on these assumptions. Macro investing has many advantages and disadvantages. Here we assess its five key assumptions:
- Big ideas dominate – Macro investors believe that picking the right big idea is essential. If you believe accelerating inflation will drive oil prices higher, buy integrated energy companies. If the yield curve will steepen, buy Financials. With such simplicity, this approach is very attractive. Develop the right big idea and everything else will take care of itself. In most markets this may work, but failing to identify the winners and losers in a certain segment can be devastating. In a market where certain companies dominate their competitors (i.e., Best Buy vs. Circuit City) investing on big ideas has its limits.
- Prices always revert – Mean reversion is among the most powerful forces in finance. Many traders have scored impressive gains by predicting that the prices of two similar instruments must eventually equalize. Consider Visa (V) and MasterCard (MA). These two companies are similar in nature. If V increases 10% in a week while MA declines 10%, we should eventually expect both prices to revert. In this case, short V, buy MA, and wait for the gain. Although this approach is intuitive, mean reversion occasionally goes awry. Investors who saw Lehman Brothers (LEH) underperform against other investment banks and positioned for reversion suffered large losses.
- Relative valuation – Most macro traders will look at values across many securities to determine a trade. Dell trades at a 7.4 P/E while Hewlett-Packard (HPQ) trades at an 8.8 P/E. A macro approach would say buy the lower P/E stock as it is cheaper. This approach may work over time, however it ignores that Dell might be cheaper for a good reason.
- Historical valuation – Similar to relative value, macro investors will look at values over long time periods. Many people think the current market is cheap as the Value Line median P/E is 11.6 versus 15.2 six months ago and 14.1 at the 2002 market low. Again, this approach is simple and intuitive, but it has limitations. What if the prior P/Es were artificially high and the future path of the economy warrants lower ratios?
- Quantitative efficiency – With increased computing power, many investors can harvest loads of data and distill it into trading philosophies. Macro investing allows you to determine a broad outline and then test it versus historical data. Doing so provides comfort when the approach is implemented. While I often use back-testing and historical reference points, blind reliance is dangerous. After all, many mortgage originators thought their models protected against the risk of losses. As we now know, that assumption did not work out very well.
While macro investing has clear benefits, it also has shortcomings. By thinking of the pros and cons of the five main assumptions of macro investors, you can better determine if this is the right approach to follow.
Sean Hannon, CFA, CFP is a professional fund manager.
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