In this section, we run a simple portfolio test to quantify the impact of using our macroeconomic data to improve a contrarian strategy. We continue to build off the benchmark presented by AIM, whose research explores the out-of-sample efficacy of a contrarian market-timing strategy between the S&P 500 Index and cash. Their hypothetical contrarian investor is overweight equities when the CAEY is above historical median values and underweight equities otherwise. Hence, this simple contrarian approach can be thought of as a mean-reversion strategy with the historical median as the fair value.
Specifically, we compare the performance of two contrarian strategies whose only difference is the fair valuation used to form the portfolio:
- Historical Contrarian: Overweight equities when CAEY is above its historical median CAEY.
- Macro-Vol Contrarian: Overweight equities when CAEY is above Equilibrium CAEY.
By building off AIM’s benchmark we are setting the bar relatively high for contrarian investing. First, we rebalance monthly, which tends to skew the performance toward strategies such as momentum rather than value. Second, the investment decision used in our portfolio test ignores the actual yield on cash, the other investment opportunity. Indeed, on several past occasions, stocks, even though expensive, still provided a more attractive expected return than cash, whose return is controlled by the Federal Reserve. We believe, however, that by setting a high bar for our portfolio test, we can offer more transparent and compelling evidence.
The equity allocations that result for both historical contrarian and macro-vol contrarian strategies are nearly identical in the early years of our analysis. After the early 1950s, however, as the level of macroeconomic volatility starts to fall, the holdings of the macro-vol contrarian strategy begin to deviate from those of the historical contrarian strategy. We observe that significant changes in macroeconomic volatility are reflected in the allocations of the risk-conditional strategy as it gradually reacts to the changing environment, resulting in larger relative allocations to equities.