Understanding Market Regimes
4 min read

Understanding Market Regimes

Understanding Market Regimes

Dear readers,

This is the last piece of our layer by layer exploration. We first learnt about the economy and why it runs in cycle, then about asset classes, multi-asset class portfolio and risk profile. Today we will focus on financial regimes, market indicators and Market regimes.


  • Stocks for the long run?
  • What are Market Regimes?
  • How to optimize asset class allocation with market regimes?
  • Examples

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Stocks for the long run?

The story people are told is the stock market is a way to invest money in companies. It allows companies to raise money in order to grow more: they exchange ownership of themselves for cash. Hence the stock market is a way to allocate money to the best projects.

This simple story is partially true: most company don't fund themselves with the stock market. They fund themselves with debt. Most of the time when you buy a stock, you are buying it from someone else (who probably bought it from someone else). The guy who bought it from the company is usually very distant from you.

Still some version of this story is right: the stock market works as if people were investing money in companies. And companies can raise money by selling stocks. So the value of the stock should be somewhat linked to the underlying value of the company (and grow with time as the company grows).

On a macro-level, our intuition is that investing in stocks is like investing in the GDP growth. Because companies make a large portion of the GDP, right? Well it is not as simple. Good GDP growth does not mean it is a good time to invest. In fact there is almost zero correlation between GDP growth and stock market performance.

That’s why I think stock for the long run, most of the time is a better approach :)

We will use Market Regimes to help us identify when “most of the time” is true.

What are Market Regimes?

Financial markets and the economy go through cycles. We hear about bull and bear markets. We hear about economic booms and recessions. But we don't talk quite as much about market regimes.

A regime is a particular iteration of a particular phase of a market cycle. Understanding regimes is important because markets are adaptive systems: investors respond dynamically to changes in the economic environment. Hence the economic environment influence their preferences for different cash flow profiles. These changing preferences are key drivers for asset prices.

What defines market regimes?

  • Economic growth (GDP growth)
  • Inflation
  • Interest rates (cost of capital)
  • Liquidity
  • Unemployment
  • Credit expansion/contraction
  • Market volatility

In order to benefit from (and to protect from) market regimes, investors can optimize their asset allocations.

How to optimize asset class allocation with market regimes?

Traditional static portfolio approaches have limitations and weak diversification. During past crisis, many investors found their supposedly diversified portfolios had correlations that moved to one in times of crisis and fell in lockstep. That is the greatest challenge investors face: finding an investment strategy provides competitive returns while reducing downside risk in both stable and changing market environments.

The trick: dynamically adjusting the weights of our multi-asset class portfolio according to market regimes.

However identifying market regimes is not an easy task, we don’t want to become “market timers” and have to predict every market transition. Therefore our portfolio must also be robust to different market regimes.

It is a game of fine tuning the weights over time.


The ball game: don’t fight the market.

Deflationary regime

A deflationary regime causes the nominal costs of capital, labor, goods and services to fall. In order to protect their capital investors sell stocks and buy long-dated treasury bonds.

Inflationary regime

In this regime, the opposite happens: the nominal costs of capital, labor, goods and services rise. It is the default state of the economy, as policymakers try to keep a positive (and limited) inflation.

If the inflation is too large, investors will sell long-dated bonds (because their yields are lower than expected inflation plus default losses) and buy real assets.

Gold, real estate, treasury bills.

Growth regime

Investors bid up stocks and sell long-dated bonds

“Before the covid-19 crisis” regime

Before the pandemic we were in a regime characterized by:

  • Slow growth
  • Low inflation
  • Near zero interest rates
  • Plenty of liquidity
  • Low unemployment

In the financial markets large caps were outperforming small caps, expensive stocks outperforming cheap stocks, momentum outperforming reversion, low volatility outperforming high volatility.

“What to do now?” regime

That’s the subject of next week :)

That’s all for today! You didn’t fully grasp the idea yet? Don’t worry next (and the following) week we will cover more specific examples.

Also, if you have any question or feedback: leave a comment :)

See you next week!

Kevin from Hook

Further readings:

This newsletter does not provide investment advice
As always, trading activity is risky and exposes you to loss of capital. Never invest more than you can afford to lose. Never. The information presented on this page (and every other) are not investments counsels. Your use of this content is at your own risk. The content is provided “as is” and without warranty of any kind, either expressed or implied. All views and opinions expressed here are the author’s own, and are not representative of the views of any current, past or future employer.

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