GavekalResearch Ideas
October 9, 2024
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Four Quadrants And
The Monetary Illusion
Charles Gave I have just finished writing a small book with the working title The General
[email protected] Theory of Portfolio Construction. It aims to summarize what I have painfully
learned on this topic over the last 50 years and should be published by Gavekal
in the coming months. In today’s report, I will draw on the book’s findings,
which are rooted in my Four Quadrants framework. I must say that at this
moment in markets, the macro approach seems more relevant than ever.
The axes in our usual traditional four quadrants are as follows:
1) The horizontal axis shows if the economy is growing, or not.
2) The vertical axis shows if general prices are accelerating, or not.
This matrix leads to my four economic quadrants: (i) deflationary growth,
(ii) inflationary growth, (iii) inflationary bust and (iv) deflationary bust.
For decades, I have tried to find a tool—or a series of tools—that would show
precisely where I am in this matrix. For years, using official data measuring
economic activity and prices, I have more or less failed.
And then, I had a eureka moment: I decided to use market data rather than
official data, and this seems to have yielded useful results.
A core dictum of mine is that a modern economy can be thought of as energy
A modern economy can be thought of as transformed. Hence, energy is the core economic input, while the outputs are
energy transformed goods and services, which should have a higher value than the input.
The energy cost constraint
Some 80% of energy consumed in the world comes from coal, oil and natural
gas and the prices of these three energy sources tend to converge towards the
most easily transported one, oil. So, I take the cost of energy to be the WTI
crude contract, for which I have prices dating back to 1900.
The output reached using the energy input is the value added by the private
sector in the economic system. The variations in the market values of this
production is approximated by stock market returns.
I assume that if stock market returns rise Being a good marginalist, I then make the assumption that so long as stock
faster than the oil price, energy is being prices rise faster than the oil price, energy is being transformed productively,
transformed productively and thus economic growth should naturally follow.
These periods are shaded green in the chart shown overleaf. The next obvious
question is what if the WTI price rises faster than stock market returns (as
denoted by non-shaded areas in the chart overleaf)? In this case, there is a
high chance that the US economy will stop growing and equity investors will
end up being miserable.
So, my first proposal for the revised four quadrants is to replace “economic
activity” on the horizontal line with a new reading of “energy efficiency”.
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GavekalResearch Ideas
October 9, 2024
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If the shaded area is green, it means that the economy in question—in this
The relationship between the S&P 500 and case the United States—must be on the right hand side of the four quadrants,
the oil price tells us a lot about the state of either in a deflationary boom (bottom right) or in an inflationary boom (top
the macro economy right). When the chart is left unshaded, it means that the economy is either
experiencing an inflationary bust, or a deflationary bust.
The rule to determine whether we are on the right or on the left side of the
four quadrants is simple: a reading of +1 is assigned if the S&P 500/oil-price
ratio is above its seven-year moving average (green shading); a reading of
-1 is assigned if the S&P 500/oil-price ratio is below its seven-year moving
average (no shading). Today, with this ratio being above its seven-year moving
average, I know that we are on the right-hand-side of the four quadrants.
The debasement question
I then move to the old “inflation axis”, where I will propose a change to past
practice. The key question for investors, I would posit, is not whether prices
Next, I need to know if the US bond
are going up or down, but whether the bond market is protecting them against
market is acting as a proper store of value
rising prices. That resolves to the question of whether the US bond market is
acting as a proper store of value, or not.
To answer this question, gold is used as a standard of value, or unit of account.
To do so I compute a ratio between the total return on a US 10-year constant
duration treasury bond and the value of an ounce of gold measured in US
dollars. If the ratio is above its seven-year moving average, the bond market
has been acting as a proper store of value, and the US economy must be
situated somewhere in the bottom two quadrants.
If the bond market return is lower than its seven-year moving average, the
currency is being debased, and the US economy must be situated somewhere
in the upper two quadrants.
As shown in the chart overleaf, it can be seen that there are long periods when
the US bond market acts as a proper store of value, followed by long periods
when gold has been a better store of value.
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October 9, 2024
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Here again, the decision rule involves a +1 score if the treasury bond market
outperforms gold and -1 should gold outperform bonds. Hence, for the first
time since establishing the Four Quadrants framework in 1978, I propose to
I am changing the name of the axes of
change the names of the axes. The horizontal axis will now measure if the
the Four Quadrants for the first time since
establishing the framework in 1978 economy is, at the time, energy efficient or energy inefficient. The vertical axis
shows if the currency is acting as a store of value and is thus labeled as being
either a “good currency” or a “bad currency”.
Hence, the economy in question can be in one of the following four states.
1) Energy efficient/good currency (+2): bottom right of the Four Quadrants
equates to a deflationary boom.
2) Energy inefficient/bad currency (-2): top left of the Four Quadrants
equates to an inflationary bust.
3) Energy efficient, bad currency (0): top right of the Four Quadrants
equates to an inflationary boom.
4) Energy inefficient, good currency (0): bottom left of the Four Quadrants
equates to a deflationary bust.
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October 9, 2024
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Next, consider the chart below, which combines the S&P 500/gold ratio and
the readings of my updated Four Quadrants framework.
Using the new matrix, both favorable
quadrants and unfavorable quadrants can
be clearly seen over the last century
You may ask why I value the S&P 500 in gold terms? The reason was well
understood by economists of the past, namely the effect of a monetary
illusion. Consider the chart below, which shows that when measured in gold
terms, the US stock market has gone sideways since 2018.
Since 2018, US stock market returns can The reality is thus that the US dollar has been going down against gold and
be seen to amount to a monetary illusion US stocks and the gains in both assets are a monetary illusion. In light of this
reality, I would make the following comments:
1) All true US bull markets, as defined by S&P 500 rising in gold terms, have
taken place when the economy was in the bottom right quadrant.
2) All Ursus magnus variety bear markets—the big destroyers of capital—
have taken place when the economy has been in the upper left quadrant,
or the old inflationary bust.
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October 9, 2024
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3) When the economy is in the upper right or lower left quadrants, nothing
too dramatic tends to happen.
The current configuration in my revised 4) In a true US bull market, setbacks in the S&P 500 such as those caused by
Four Quadrants calls for investors to be a US recession should be bought by smart investors.
very cautious 5) When the economy is in the upper left quadrant, any rally should be sold.
6) Today we are in the top right quadrant, where gold is supposed to outpace
an indifferent US stock market. This has been the case since late 2022.
7) The seven-year moving average of the S&P 500/gold ratio has been
broken (as opposed to the S&P 500/oil-price ratio) and in the past this
has never been a good omen.
8) Such a breakdown in the S&P 500/gold ratio has often preceded the
breakdown of the S&P 500/oil-price ratio by a few months.
Conclusion
Given that the US economy is already situated in the upper right quadrant
of my matrix, it is becoming dangerous to hold US equities without a sizable
gold hedge. And by sizable, I mean at least 25% in gold.
Moreover, the current favorite way of owning equities—indexing—means
that investors are inherently betting against a pronounced rise in fossil fuel
prices. On face value, this suggests that the US economy should not, for the
foreseeable future, face an inflationary bust. It goes without saying that I
consider this to be a bad bet.
As of today, fossil fuel-based energy producers represent less than 5% of the
Energy could be the best hedge to the benchmark US equity market index, versus 30% in 1983. If investors are not
next market bust able to buy gold as a hedge, I would advise adding a large position based on
the fossil fuel energy index.
If we enter a new energy crisis, I would expect fossil fuel producers to do very
well and to at least partially protect a standard portfolio. Today’s indexation
bias amounts to having an equity portfolio made up of 95% energy consumers
and 5% in energy producers. That strikes me as being unreasonable.
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