Index Universe carried an interview with Tad Rivelle, the chief investment officer at Trust Company of the West, that touched on the difference between finance theory and the reality in the markets. Mr. Rivelle is mainly a bond guy and the interview mostly discussed interest rates and so on, but it contained this gem:
IU.com: We’re hearing projections of 3.5 percent rates by next year, 4.5 percent by 2015. What happens if the bond market decides to rush there at once rather than to gradually get to those levels? Could it derail the economic recovery?
Rivelle: Yes. In fact, that’s precisely what we saw when we had that taper tantrum back in May and June. It was catalyzed by Bernanke’s statement to the effect that the Fed was carefully considering an initiation of a taper late this year, and the bond market sold off horrifically in a very short period of time. It was a generalized deleveraging. I think it frightened the Fed, and consequently they walked those comments back.
The conflict here is that the Fed tends to approach things from a model-driven academic perspective—what’s supposed to happen in theory versus the realities of the marketplace. When people are looking to front-run one another to offload risk before the next guy does, these models basically go out the window.
How the bond market will respond is absolutely unknown, but it’s more typical for the bond market to move very rapidly, to gallop to what it believes is the next point of equilibrium and not to sell off gradually. I’ve never seen that happen.
I put the fun part in bold—in a real market, academic models go out the window and human behavior takes over. Mr. Rivelle points out that markets trade on perception, and often make adjustments abruptly when perceptions change.
To me, this is the real strength of tactical asset allocation driven by relative strength. As perceptions change, different securities or asset classes come to the forefront and others fade away. As relative strength investors, we don’t have to predict what these changes might be. We simply have to adapt our portfolio as the changes occur. Relative strength adapts to changes in human behavior, not some elusive equilibrium proposed by academics.
