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Step 1

We use our Global Macro Risk Matrix to nowcast the Market Regime, which investors must position to avoid FOMO or suffering a significant drawdown in their portfolio.

Since Jan-98, there have been an average of 2-3 RORO phase transitions per year that investors needed to risk manage to remain on the right side of market risk, which is shorthand for maximizing upside capture in bull markets and minimizing downside capture in bear markets. RORO = risk-on to risk-off or vice versa.

The key takeaway here is that active investors have only needed to make 2-3 critical decisions in their portfolios per year to generate superior risk-adjusted returns.

Our Market Regime nowcasting process helps 42 Macro clients time those pivots effectively.

Step 2

Our Volatility-Adjusted Momentum Signal and Global Macro Risk Matrix Market Regime nowcasting process are incredibly powerful tools for identifying trends and inflections in momentum across asset markets.

As such, we use the Market Regime signal to communicate to clients the appropriate asset allocation and portfolio construction risks they should be taking in their portfolios at the current juncture.

Step 3

Investors that prefer a simple asset allocation solution can use the 42 Macro KISS Portfolio Construction Process to generate superior risk-adjusted returns. KISS stands for “Keep It Simple and Systematic”.

Investors that prefer a more sophisticated portfolio construction solution can use the 42 Macro Discretionary Risk Management Overlay aka “Dr. Mo” to generate superior risk-adjusted returns.

Dr. Mo is the primary tool we use to help our buy side clients and sophisticated retail traders remain on the right side of market risk, which, again, is shorthand for maximizing upside capture in bull markets and minimizing downside capture in bear markets.

If an ETF is bullish (or bearish) VAMS and that is in line with how the underlying asset should trade in the current Market Regime, then Dr. Mo will prescribe a “LONG (or SHORT): Max Position” Proper Trade recommendation.

If an ETF is neutral VAMS and the underlying asset should be bullish (or bearish) in the current Market Regime, then Dr. Mo will prescribe a “LONG (or SHORT): Half Position” Proper Trade recommendation.

Dr. Mo will prescribe a “No Position” Proper Trade recommendation if the VAMS for the underlying asset is the opposite of what it should be in the current Market Regime.

Investors should allocate assets according to Dr. Mo’s Proper Trade recommendations, only changing positions when the corresponding Proper Trade
recommendation changes.

Investors that prefer to use our macro risk management overlay to generate superior risk-adjusted returns trading single stocks
can do so as well.

Our nowcasts of the Market Regime will tell you what stocks to buy and sell, when to buy and sell them, and how much to buy and sell.

For example, if we are in the REFLATION Market Regime in which growth is or perceived to be accelerating (or persistently surprising to the upside) and inflation is also perceived to be accelerating (or persistently surprising to the upside), our data shows that the best performing stocks in REFLATION are Information Technology and Mega Cap Growth stocks.

Therefore, in the REFLATION Market Regime, stocks you would want to buy might include the NASDAQ 100 ETF (ticker: QQQ) or the highest-weighted stocks in that ETF, such as Microsoft (ticker: MSFT), Apple (ticker: AAPL), NVIDIA (ticker: NVDA), Amazon (ticker: AMZN), and Meta Platforms (META).

Another example would be if our Global Macro Risk Matrix signaled a transition to the DEFLATION Market Regime in which growth is or perceived to be decelerating (or persistently surprising to the downside) and inflation is also perceived to be decelerating (or persistently surprising to the downside).

In DEFLATION, our data shows Information Technology and Mega Cap Growth stocks do not perform as well as others, so you would want to either sell those stocks, reduce your exposure to them, or hedge those positions.

Historically, defensive equity factors like Health Care (ticker: XLV) and Low Beta (ticker: SPLV) perform best in the
DEFLATION Market Regime.

An investor positioning for DEFLATION would buy the top stocks within the XLV and SPLV ETFs.

That includes names like Eli Lilly (ticker: LLY), UnitedHealth Group (ticker: UNH), Johnson & Johnson (ticker: JNJ), Coca-Cola (ticker: KO), McDonald’s (ticker: MCD), and Berkshire Hathaway (ticker: BRK/B).

Conclusion

In short, respecting the Market Regime and responding to changes therein has been proven by many of the world’s top asset managers as the best way to compound returns over time.

It helps investors distill signal from the ever-growing flood of economic and geopolitical noise, and it helps investors overcome many of the common behavioral heuristics that prevent them from achieving their strategic
investment objectives.

Said differently, participating in the evolution of the Market Regime forces a degree of humility into any investment process – humility that prevents financial ruin and allows investors to compound returns faster than they would if their portfolio positioning was solely reliant upon fundamental predictions alone.

No one will ever be that good at consistently and accurately predicting the future – including us and our forecasting track record is among the elite.

The sooner you accept that humility is the best path forward, the better off your or your clients’ portfolio(s)
will be.

Macro is an essential concept for investors to understand because it is a fundamental driver of investment performance. Macro, short for macroeconomics, is the large-scale study of economies and the interaction of economic and political factors that affect those economies. Macroeconomics focuses on the performance of economies with respect to growth, inflation, employment, interest rates, liquidity, government policy, andcorporate profits. Understanding these factors and their interrelationships are important because of the significant impact they have on financial markets and our
investment portfolios.

Growth

This refers to the rate at which an economy grows over time. High rates of economic growth typically lead to greater corporate profits and higher stock market returns.

Inflation

This refers to the rate at which prices for goods and services increase over time. Too much liquidity from fiscal and/or monetary stimulus can create excess demand which can drive up the prices of those goods and services. High inflation often leads to lower corporate profits and stock market returns as companies struggle to maintain profits because their costs are increasing more than
their revenues.

Employment

This refers to the number of people employed in an economy over time. High and/or rising employment levels are typically good news for the economy and the stock market because it results in greater consumer spending from wage earners which increases the demand for goods and services.

Interest Rates

These refer to the cost of borrowing money from banks or other financial institutions over time. Low interest rates often result in increased economic growth and higher stock market returns as consumers and companies and can borrow money cheaply to finance purchases and
expansion plans

Liquidity

This refers to how easy or difficult it is for people and business to borrow money. Declining interest rates, easing lending standards, and rising prices of loan collateral like homes or government bonds all contribute to improving liquidity conditions within an economy. Higher liquidity tends to lead to higher economic growth.

Government Policy

This refers to the influence governments have on the economy. Government policy that matters most to us is driven by central banks and fiscal authorities. The role of central banks within the economy is to implement ‘monetary policy’ which affects the price (interest rates) and supply (liquidity) of money in the economy. This is done through three channels: 1) setting short-term interest rates to influence the price of debt within the economy; 2) ‘quantitative easing (tightening)’ in which the central bank buys (sells) assets – usually government debt – from (to) the market; and 3) forward guidance, in which the central bank outlines its monetary policy intentions to influence sustained behavior among market participants. The role of fiscal authorities within the economy is to implement ‘fiscal policy’ which is the total quantity of goods and services demanded by the government and how the government finances those outlays – either via collecting taxes or issuing debt. Government policy can have a significant impact on growth and inflation, and, by extension, the performance of stocks or other securities traded on financial markets around the world.

Corporate Profits

This refers to the income companies generate from their sales after costs, taxes, and other business expenses. Corporate profits are most commonly cited on an earnings-per-share basis for individual companies and aggregated for the broader stock market. High rates of corporate profit growth typically lead to higher stock market returns.

By understanding the Macro and how to measure and forecast economic performance investors can make better informed decisions about the types of securities to own in their investment portfolios and the timing of those investments. Staying informed on macroeconomic trends will help investors manage risk while also maximizing potential returns from their investment portfolios over time. The importance of staying informed cannot be understated; understanding how macroeconomic trends influence investments will help ensure that your portfolio remains profitable even during times of economic uncertainty.

The decisions of global central banks who set interest rate and monetary policy which drives global liquidity rely heavily on macroeconomic data. That data helps economists and investors identify conditions related to economic growth, inflation, income, employment, and interest rates that shape our economy. Broad trends in macro data inform central banks which, in turn, adjust interest rates and monetary policy in order to balance inflation and maintain a healthy economy. The macroeconomic landscape constantly changes as governments make decisions about fiscal policies; understanding the ongoing evolution of macroeconomics is essential in helping countries ensure their long-term economic success.

Equally important are external factors like government policies, financial regulations, and the liquidity within markets. By taking macroeconomic data into account when making investment decisions, we can better identify trends and opportunities that will benefit our portfolios in the long run and help us protect our portfolios against risks that could be detrimental in the short run.

The economy is the core foundation of our society, and understanding how it works is essential to investing successfully. The economy is the series of goods and services transactions between buyers and sellers that are necessary to support those who are living and operating within the economy. What makes an economy function is the series of transactions that occur between buyers and sellers (people, businesses, central banks and governments) within the economy through the exchange of cash or credit. The total volume of those transactions drives economic growth and the fluctuations in that economic growth occur within the business cycle. Ultimately, by understanding how the economy works, we can piece together themes and concepts for how to read and react to the economy and make the most out of it as investors.

What is it? The volume of goods and services transactions in an economy occur within a business cycle. The business cycle is the fluctuation of economic activity over period of time. It is the series of economic activities that represent expansions and contractions in an economy. The most common measure of economic activity is called gross domestic product (GDP) – the measure of the total value of all finished goods and services within a country’s economy. GPD is often looked at to provide an economic snapshot of the size and growth within an economy.

The foundation for the most successful investors in the world is built on a fundamental understanding of the business cycle. Knowing where you are in the business cycle (expansion or contraction) and the relationship of economic variables (industrial production, sales, employment, income) related to each phase of the business cycle are critically important to investors and their portfolios. Not having that information is the equivalent of driving blind. You cannot be a successful investor without knowing where you are in the business cycle what variables are driving the business cycle. Once armed with the information (macro data) that drives business cycles, you can begin to forecast where were going next and position your investment portfolio accordingly based on the historical performance of asset classes in each phase of the business cycle. You’ve got to know where you are in business cycle to know where you’re going.

As you can see from the chart, there are four phases to the business cycle that generally last between a few quarters to a few years apiece. They are expansion, recession, depression and recovery. The height of the peaks and depth of troughs always varies, but if you know where you are in the business cycle you will know how to allocate your investment
portfolio accordingly.

How do I know what phase of the business cycle I’m in? By looking at the macro data that most accurately reflects the economic growth and inflation in an economy. We will discuss our favorite macro indicators in another chapter, but remember we want to see it highly correlated to growth (hint: Real GDP) and inflation (hint: Headline CPI).

Each phase of the economy, or as we like to call them, Macro Regimes, can be defined by whether or not economic growth and inflation are rising or falling. For example:

The Recovery Phase, often referred to ‘Goldilocks” is where economic growth is rising and inflation is falling – sounds fantastic. So how should my portfolio be aligned? Looking back at historical asset performance in the Recovery Phase tells us the best places to be invested in this phase of the business cycle are the equity and debt of companies in cyclical industries like consumer discretionary and industrials, and other risky assets like Bitcoin and
industrial metals.

However, in the Depression Phase of the business cycle, historical asset performance tells us my investment portfolio should be more defensive, favoring assets such as bonds, the equity and debt of companies in mature industries like consumer staples and utilities, and other defensive assets like the US dollar and gold.

This simple premise of understanding the business cycle, where we are in it and forecasting where we go from here, using macro data is the foundation upon which 42 Macro’s research was built. We will go into much greater detail on this in our 42 Macro Investing Class.

Do you know what fuels the economy? It is credit. Credit plays an integral role in economic growth, enabling businesses to obtain capital for expansion and consumers to buy the vital goods they desire. The credit cycle is an essential component within the business cycle. It is heavily influenced by interest rates which have a material impact on the volume of transactions within an economy. The level of interest rates generally dictate how much money consumers and businesses are willing to borrow. When interest rates are low, consumers are incentivized to borrow more. This fuels an increase in economic activity as the demand for credit increases while businesses and consumers finance their investments and purchases. On the other hand, when interest rates are high, borrowing costs are too expensive for many borrowers and credit
remains scarce.

Interest rate policy in any economy is set by it’s country’s Central Bank. The Central Banks role in the economy is to implement ‘monetary policy’, thus effecting the supply of money (liquidity) in the economy by influencing interest rates and the creation of new money. The Central Bank dictates interest rate policy in order to control that amount of credit and liquidity within that economy. If the Central Bank sees the economy growing too fast, the CB will move to raise interest rates in order to increase the cost to borrow money and reduce the volume of transactions in the economy. Vis-a-versa, if the economy isn’t growing or is growing too slowly, the CB will lower interest rates in order to decrease the cost to borrow money and increase the volume of transactions in the economy. The greater the amount of credit created in an economy, the greater the amount of liquidity in the economy.

In order for credit to be created in an economy, a lender and a borrower must come together and agree on the terms and cost of that borrowing. The primary cost of borrowing money is the interest rate. The higher the interest rate, the more expensive the cost of borrowing. The lower the rate, the cheaper the cost. Low interest rates incentivize borrowing, which stimulates the purchasing of goods and services in an economy.

Buying a house is a good example. Let’s say you can afford to pay $3,000 / month for your mortgage loan payment. At a 6.0% interest rate, the cost of a 30 year, $500,000 loan = $2,998. Perfect. So at a 6.0% interest rate, you can afford to borrow $500,000. What if the rate was much lower, say 3.0%? That same $3,000 per month budget enables you to borrow (and spend) $200,000 more (total of $700,000) money. This is how credit and additional liquidity are created through interest rate policy. Lower interest rates creates more liquidity, which creates more purchasing power and a greater demand for goods and services
in an economy.

In a world where there is so much data and so many talking head narratives to parse through, it’s important to understand what data really matters so you’re not wasting your valuable time and energy getting whipped around by data and narratives that really don’t have an effect on the longer term trajectory of the business cycle and
financial markets.

The release of macro data is often times a significant catalyst for financial markets. Differentiating the signal from the noise is imperative. Most of the time it’s not about the actual reported data, but what about that data was expected AND priced into market expectations. If the market has a meaningful response to new data, pay attention, there might be something new or different about it relative to what was “priced in”.

Whether you’re investing in the stock market on a daily, weekly, monthly or quarterly basis, it’s important to have some basic understanding of the business cycle and that macro data that is showing us where we are in that cycle. As an investor you cannot expect to pick every top and bottom of the market, but with the right macro data you can get an excellent read on the trending direction of economic growth and inflation. Knowing where you are in the business cycle and being able to forecast where you’re going is critical. Not having that information is the equivalent of driving blind.

In this chapter, we’re going walk you through the high level macro economic data that matters most – the data that tracks economic growth and inflation AND is most highly correlated to the ups and downs in financial markets. At 42 Macro we are have spent our careers analyzing macro data and back testing the financial markets reactions to that data. When looking at data in general, we like to see a long
history of reporting.

This way we can look back to see how the market, over long periods of time and through numerous business cycles have responded to the data. How closely does the data correlate to the movements in the financial markets.

Given that markets are always forward looking, the data that typically matters the most is survey data (because it speaks to survey participant plans and expectations for the future) that measures economic growth as opposed to historical ‘hard’ data (which documents what happened in the past). That said, historic data is also important because it is often the data Central Banks and the Federal Reserve anchor on in making decisions related to interest rate policy and money creation. Interest rate policy is the key lever that is pulled to keep inflation at the desired single digit level. If inflation starts to rise above those levels, the Federal Reserve will raise interest rates in order to prevent the economy from overheating. When growth is slowing and unemployment is rising, the Federal Reserve will lower rates in order to stimulate economic growth
and job creation.

The data is what drives the monetary policy decisions and as you know, those decisions significantly impact financial markets. Often times, the type of economic environment we’re in (inflationary or deflationary) will direct your focus more towards the data most closely aligned with
economic environment.

ISM Data

One of our favorite forward-looking data sets for measuring economic growth was created by the ISM (Institute for Supply Management). The ISM is a nonprofit supply management association with more than 50,000 members across 100 countries established in 1915. It is the oldest of its kind, providing education, research, certification and development for individuals and corporations in the supply management and purchasing businesses.

On a monthly basis, the ISM Manufacturing and Services business committee conducts a survey from more than 400 US manufacturing and service company senior purchasing managers across ~ 19 industries, weighted by their contribution to US GDP on topics in 10 key areas:

Employment
New Orders
Supplier Deliveries
Backlog
Inventories
Customer Inventories
Prices
New Export Orders
Imports
Buying Policy

The survey also includes questions about changes in business conditions. This survey, which dates back to 1931 (although consistent data didn’t start until 1948) is one of the most valuable measures of private sector economic business activity and provides the best insight on trends in the global business cycle. The survey results are published monthly in the ISM’s Report on Business and includes a numeric composite via the ISM Manufacturing Index to summarize the results. The ISM Manufacturing Index is the best leading indicator for
the US economy.

PMI Data

The ISM also publishes a composite of indexes in this monthly report called the PMI (Purchasing Managers Index) that include a more granular Manufacturing PMI and the Services PMI (non-manufacturing).

Each of the key areas represented in the composite indexes are weighted equally to derive a number from 0 – 100. An ISM / PMI reading greater than 50 generally reflects business expansion and a reading below 50 reflects business contraction. An ISM reading below 50 has resulted in a recession 60% of the time. An ISM reading below 47, 80% of the time and an ISM reading
below 46, 100%.

Markit PMI Data

In Europe and the rest of the world the PMI counterpart is Markit who compiles purchasing managers survey data from over 20,000 companies in 50 countries and key regions throughout the world including the Europe.

GDP Data & Inflation Data

GDP (gross domestic product) is another data set we like for measuring economic growth. GDP is the measure of the total value of all finished goods and services within a country’s economy and is often looked at to provide an economic snapshot of the size and growth within that economy. There are four components of GDP, personal consumption, business investment, government spending and net exports. These tell you what any given country is good at producing. Although GDP and revisions to GDP are historical, lagging data sets we like them because they are highly correlated to ISM and PMI data and they provides a good longer term direction of an economy. GDP and ISM also happens to be highly correlated to the S&P 500 and S&P 500 earnings. Lets look at the charts.

ISM / GDP
ISM / S&P 500 earnings
ISM / S&P 500

As you can see there is a long history of data here (through numerous business cycles) that we can back-test, measure and map. This means that based on those back-test results we can forecast with a high degree of confidence the future direction of the ISM / GDP and therefore the future direction of S&P 500 earnings and S&P 500 stock performance.

OECD CLI Data

Another historic data set we like to measure and map economic growth alongside GDP is the Organization for Economic Co-operation and Development (OECD), Composite Leading Indicators (CLI) index data.

The CLI index measures overall economic health by combining ten leading indicators including: average weekly hours, new orders, consumer expectations, housing permits, stock prices, and interest rate spreads. It is designed to provide early signals of turning points between expansions and slowdowns of economic activity. The OECD compiles CLIs for 29 member countries, six for non-member economies and seven for country groupings such as the Eurozone.

We like CLI data because the methodology is consistent across geographies and unlike historic GPD data, CLI data is released monthly. This indicator allows investors to confirm and react to inflections the trending rates of change of economic growth much faster than with quarterly
GDP statistics.

Inflation Data – Consumer Price Index (CPI)

As everyone knows, inflation the change in the level of prices as measured by publicly available and/or widely followed periodic indicators like the Consumer Price Index, Producer Price Index, Personal Consumption Expenditures Price Index, etc. We prefer Headline CPI because that statistic tends to have the most predictive value with respect to forecasting inflections and/or persistence in the momentum of key financial market indicators like
interest rates.

BLS Employment Data

The Bureau of Labor Statistics (BLS) non-farm payrolls report is another very important forward-looking survey we follow. Non-farm payrolls measures the number of employed workers in the US excluding farm workers, some government workers, private households, proprietors and non-profit employees.

On a monthly basis the BLS conducts two comprehensive surveys (the Household Survey and the Establishment Survey) to private and government entities throughout the US about their payrolls. The Household Survey includes the unemployment rate in total and by gender, race education, age, reasons for unemployment and the participation rate. The Establishment Survey covers the total nonfarm payrolls added by the entities reporting each month and by industry category, durable goods, non-durable goods, services and government, details on hours works and details on average hourly earnings. The BLS then reports the findings from these two monthly surveys through a “Employment Situation” report which includes the unemployment rate. This labor report is probably one of the most widely followed reports in macro as employment trends and an economy’s ability to grow is largely driven by it’s ability to create jobs.

Given that the dual mandate of the Federal Reserve is maximum employment and price stability (i.e. keep inflation positive but in the low single digits) this BLS and CPI data gets a lot of attention by the Fed and by
stock market participants.

In summary, the object of this chapter was to point out the most important macro data that we look at in order to evaluate and forecast economic growth and inflation. Then with that information back tested against investment asset classes we can make probabilistic bets on where to invest (stock, bonds, commodities, currencies, precious metals, etc.) right now.

The almighty US dollar – the reserve currency for the World. The US dollar is the currency through with most assets are transacted in globally. From 1999 – 2019, the US dollar accounted for 96 percent of trade invoices in the Americas, 74 percent in the Asia-Pacific region, and 79 percent in the rest of the world. (Source: Federal Reserve)

According to the IMF, the US dollar is the most commonly held currency among external bank assets with a balance of around $16.7 trillion and 60% of central bank reserves are in US dollars, with the Euro a distant 2nd at 20%. The Bank of International Settlements (BIS) tells us there is $500 trillion in global derivative transactions denominated in US dollars.

So you get the point. The US dollar is King. The direction of the US dollar has a significant impact on the assets in any investment portfolio. There’s a popular saying amongst financial market participants and analysts, “get the direction of the dollar right, and you will get the direction of most other assets right.”

Generally speaking that impact tends to look like
the following:

This all seems so make sense to lower US dollars means interest rates are lower, financial conditions are loose and therefore there are more dollars / more liquidity sloshing around international trade and financial markets, thus stimulating growth and buoying global risk assets. We think of the US dollar as the residual of the supply and demand of global dollar credit. If US dollar going up, US dollars are scarce and credit / liquidity is tight. Dollar down, dollar credit easing allows companies to refinance and grow. Most investment portfolios have exposure to the US dollar. Therefore, every investor should have some basic awareness of the US dollar strength or weakness and the likely effects it has on
investment portfolios.

42 Macro Reading List

The Misbehavior of Markets – by Benoit Mandelbrot

Principles – by Ray Dalio

Thinking Fast and Slow – by Daniel Kahneman

The Most Important Thing – by Howard Marks

King of Capital– by Steve Schwarzman

Mastering the Market Cycle – by Howard Marks

Models of My Life – by Herbert Simon

Letters to a Young Athlete – by Chris Bosh, Pat Riley

A Man for All Markets – by Edward O. Thorp

Tribe of Mentors – by Tim Ferriss

Mastering Fear – by Brandon Webb & John David Mann

David and Goliath – by Malcolm Gladwell

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