The future is uncertain so we prepare political-economic scenarios that cover the range of what may happen, with corresponding probabilities, over the next 12 months.
- The scenarios are characterized by macroeconomic variables for each region of the world such as real GDP growth, inflation, exchange rates, central bank overnight rates, and the global price of petroleum, among others.
- We also have a set of estimated equations that forecast a long list of additional consequences including: productivity, unemployment, unit labor costs, profits, dividends, and long term interest rates. These equations are continuously re-estimated and the parameters reviewed to determine relevance.
- We combine the scenario forecasts and the multi-variable factor estimates to project returns for each of ten stock market sectors in each of four regions (US, Japan, Europe, Emerging Market) and for cash and U.S. government bonds.
- We carefully construct a target portfolio using the avoidance of major losses as a significant criterion.
- We constrain the portfolio by attempting to limit a projected maximum loss in a worst case scenario and a weighted expected loss across all scenarios of 10% or less.
A portfolio that was expected to lose no money in any scenario, but that was expected to participate substantially in better scenarios, is a dominant choice.