The Three Scenarios That Should Guide Investors

If you are adding to your long-term holdings of stocks and other risk assets at current market valuations, you are likely to be betting -- knowingly or not -- on a combination of three drivers of future returns; or you are planning to sell your holdings to someone who is or will be making that bet. Understanding the importance of these three scenarios, both in relative and absolute terms, indicates not only the probability of being right over time, but also the tilts you should be applying to your current “risk-on” portfolio positioning.

One of the main analytical challenges facing investors in today’s unusually fluid world, and there are many, is deconstructing the potential drivers of overall market returns into a small number of actionable and verifiable hypotheses. That means specifying a “reduced-form” equation in which just a handful of explanatory variables identify the conditions under which risk-on investors will continue to be richly rewarded.