Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Friday, November 21, 2014

Book Review: Investing From The Top Down

In Investing From The Top Down: A Macro Approach To Capital Markets, Anthony Crescenzi lays out the case for "macro" investing. Instead of trying to pick securities by scouring over company reports, one looks at the trends in the macro economy and markets. The advantage of this approach is that it requires less of a time commitment, and if one is successful, it will be easier to sidestep crises that are blundered into by those who myopically focus on what is happening to particular companies. Although billed as being useful for institutional as well as retail investors, it is not too complex and so I view the true audience as being retail investors or people who have entered finance without a background in economics.

I want to keep this review of the book fairly general, and so I do not want to cover particular detailed insights within the book. I may cover interesting subjects in separate articles. That will allow me the ability to devote more time to explaining the background to those topics.

Book Description

The book was published in a great year for macro investing (if you were on the right side of markets) - 2009, by McGraw Hill. Although the book has been out for a few years, I am reviewing it as it is one of the few I have seen on "top down" investing. The book is 281 pages, with references at the end of chapters. In the final chapter, he provides what refers to as "Golden Compasses"; his top 40 indicators for monitoring the global economy.

The book is written at a level that is aimed at retail investors, without using too much finance or economics jargon.

Anthony Crescenzi was the Chief Bond Market Strategist at Miller Tabak when the book was written; he has since moved to Pimco.

The Book's Message

Crescenzi argues that investing has become too complex, and there is a simpler and more time effective approach - the use of top down macro indicators. In practice, this means that you look at a number of economic time series in order to judge the state of the economic cycle, and invest in asset classes that do best at that part of the cycle.

At the most basic level, this usually means favouring equities ("stocks") when the economy is expanding, and getting out into government bonds when a recession hits. Additionally, you can dig deeper, and follow investment themes. For example, if you had correctly realised in the early 2000s that oil prices would rise a lot higher, that would have suggested investing in oil exploration firms.

He argues that there are now large advantages for investors to follow this approach.

  • Economic and industry data - as well as packages to analyse the data - are now widely available for free on the internet. (I have developed a personal research platform which I use to produce my blog without purchasing either data or analysis software.)
  • The rise of Exchange-Traded Funds, and in particular sector funds, along with low transaction costs, make it possible for investors to take very specific positions without losing too much money to intermediaries.
  • Over-capacity in the financial industry has meant that professional investors have squeezed out any valuation discrepancies between securities within any sector of the markets.
  • Although I am biased, there is a lot of excellent economic and financial analysis available for free on the internet, on blogs as well as sites like Seeking Alpha (where some of my articles are distributed; the site also has a non-free premium service). 
  • Top down investing takes less time than "bottom up" analysis (picking companies by scouring their financial statements), which is an advantage given the time pressures most are under. 

The final point is emphasised throughout the book. Since economic data tend to be stable during an expansion, once you have put a strategic position in place, it does not take a lot of effort to monitor your strategies. You may only need to glance at a few charts once a month, and keep up with news flow.

In addition to giving examples of how you approach the subject, he also explains various philosophies one needs to follow in order to succeed.

One philosophy is that you need to assume the consensus amongst economists is wrong; if you follow the stories spread by influential Wall Street strategists, you will end up making the same mistakes as everyone else. As an example, in 2010 economists were convinced that interest rates in the United States were unsustainably low, and rate hikes would be starting at some point in 2011. Meanwhile, at the time of writing in late 2014, the Fed has yet to hike rates. Unfortunately, it takes a bit of homework to determine where and when the consensus is wrong. The answer in the book is to follow the data and the indicators.

Another philosophy is to avoid confirmation bias - hanging around with those whose opinions agree with yours. If your world view leads to a bad investing strategy, you need to change that strategy before you wipe out your capital. However, there is a psychological tendency to want to remain with those who embrace your original thesis, and you then blame various conspiracies for your losses in the financial markets.

Additionally, you need to understand how to conceptualise economic data. Dollar amounts you are involved with are immense, and outside normal experience. You need to express data relative to some benchmark - how big is an expenditure relative to overall GDP or total consumer spending? The example Crescenzi gives is the effect of oil prices. Oil prices started rising rapidly in 2003-2004, which caused some commentators to worry about their effect on the economy. The reality is that oil prices were previously so low that spending on energy was such a small portion of consumer spending that the effect of higher energy costs were dwarfed by income gains. As he says, you needed to "do the math", and not just rely on a historical relationship between oil price rises and recessions.

Reasons To Be Cautious

I believe the book is well written, and one of the few I have seen on the investment style that I follow. (There have been a lot of macroeconomics and finance books written since the end of the crisis, but pretty much all of them have axes to grind. For example, there are at least a dozen books on preparing for the collapse of paper currencies on sale at my local mainstream book store. Although those books are interesting, they are a prime source of confirmation bias.) As a result, I would recommend the book, but the book is not perfect.

  • As one reviewer on noted, if someone buys a book on top down investing, they are presumably interested in following that path. Crescenzi probably spent too much space contrasting "top down" investing to the "bottom up" alternative.
  • He does not cover the obvious alternative to "top down" investing - passive investing. (This is doing something like putting 60% of your portfolio in an equity index fund, 40% in a bond index fund, and rebalancing as your portfolio weightings drift from those targets.) This takes even less time than top down investing.  And importantly, it is unclear whether most investors could do better than passive investing. There is a lot of old academic studies that showed that investors did fairly poorly when trying to "time the markets". However, the investors involved were probably not using top down macro techniques (since there's not a lot of people following that strategy).
  • There is a considerable learning curve to deal with. My first job outside of academia was working as a fixed income analyst, and so I had the luxury of learning the skills on the job. If the reader wants to follow the path of top down macro without any relevant experience, you will need to supplement this book with those with more technical detail (as well as spending a lot of time looking at the data). 
  • Other than equity sector funds it is often difficult for retail investors to take positions that benefit from macro analysis. He mentions the use of futures, which I would not recommend unless you have a good trading infrastructure in place (which includes having a backup with the authority and ability to manage the portfolio in your absence).  

One might think that best way of dealing with the time commitment problem is to invest in funds that follow a top down approach. Interestingly enough, this is not an area that is well served. By contrast, it is easy to find funds that are focussed particular equity strategies, such  dividend investing. There are also funds that handle the rebalancing needed for passive strategies.

There are macro hedge funds, but one would need considerable financial resources to invest in one of the well established ones with excellent long-term track records; and it is unclear how to judge the quality of smaller hedge funds that might be easier to invest in. Modern finance is highly specialised, and it excels at creating "style boxes" for classifying investing strategies on the basis of quantitative rules. However, top down macro is to general, and cannot be classified using such rules. Hence, the limited number of "off the shelf" solutions.

Concluding Remarks

The book provides a first step towards do-it-yourself top down macro investing. If you wanted to invest time in improving your portfolio's performance, it is probably the most efficient strategy. However, you will have to continue with detailed data analysis if you want to continue down that path.

Finally, the book is available at Investing From the Top Down: A Macro Approach to Capital Markets (affiliate link).

See Also:

(c) Brian Romanchuk 2014

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