The financial markets operate in a series of regimes when a certain set of economic conditions exist for a period of time. My first encounter with the concept was in 2000, when I read quantitative analyst Emanuel Derman’s paper titled “Regimes of Volatility.” Derman explained that we have periods with persistently low volatility and periods with persistently high volatility. But this is also true of other market variables such as inflation, interest rates and commodity prices. Market regimes can persist for many years, but investors often to fail to adapt.
Take the events of earlier this year. Some benefited when inflation rates began to rise and bond yields shot up after the U.S. Presidential inauguration in January on speculation that increased government spending and bigger budget deficits would soon follow. Others were poorly positioned for this regime change and fought against it, losing money in the process. But those people are now being rewarded, as 10-year yields have dropped and the old disinflation trades make a comeback.