Economic Schools of Thought and Market Performance

David Beckworth asks a really interesting hypothetical on Twitter – which economic schools would have fared well since 2009?   That is, if you’d used the general understandings of specific economic schools then which ones would have helped you navigate the markets and which ones would have hurt?

To think of this, imagine if we took the various schools of economics and their chief figurehead and then placed that person in the role of Chief Economist, Chief Market Strategic and Head of Portfolio Management over the last 5 years?  We can’t be certain how the various schools would have performed, but we can get a pretty good idea using a very general framework.

To analyze this we can take some basic assumptions about portfolio construction by building a global benchmark using the Global Multi Asset Portfolio and then constructing a general portfolio backtest knowing whether a certain school would have been bullish or bearish on certain components.

So, for instance, the benchmark portfolio would be roughly:

US Stocks: 20%

Foreign Stocks: 20%

REITs: 5%

Corporate Bonds: 19%

US Govt Bonds: 29%

High Yield bonds: 2%

Global Bonds: 3%

TIPS: 2%

CAGR: 9.7%

Standard Deviation: 3

Sharpe Ratio: 3.13

First up, the Austrians.  Here’s my best reconstruction of their portfolio where components I was unsure about I just left unchanged.  Keep in mind this is a very general hypothetical so let’s not get too emotional or anything about how I went about doing this:

US Stocks: 0% because the USD is ending due to QE and the coming hyperinflation.

Foreign Stocks: 40% to get non-dollar exposure.

REITs: 5%

Corporate Bonds: 0% to avoid USD exposure.

US Govt Bonds: 0% to avoid exposure to rising interest rates.

High Yield bonds: 0% to avoid exposure to rising interest rates.

Global Bonds: 10% to get non-dollar denominated asset exposure.

TIPS: 0% to avoid USD exposure.

Gold:  30% for inflation protection.

Precious metals: 15% for inflation protection.

CAGR:  9.5%

Standard Deviation: 18.6

Sharpe Ratio: 0.57

Not as bad as you might have expected considering how awful the rising interest rate and hyperinflation prediction has been.  But also note that the portfolio was whipped around like a rollercoaster.   The risk adjusted returns are sort of atrocious compared to the benchmark.  The precious metals and gold positions would obviously dominate the portfolio and have been extremely volatile positions for the last few years.  In fact, all of the returns in this portfolio would have come in the first 2 years of its lifetime when many people were buying metals because they actually thought that it would protect them from the coming hyperinflation…..

This is just a fun little hypothetical using a bull market portion of the cycle, but I think it gives some general idea about how useful some of the ideas of certain economic schools are when applied to a real life portfolio.  Anyhow, I have to run, but I’ll post a few of the other schools in the coming days….