This quarter, we explore the hypothesis that the modern era of Ricardian growth has ended. We further explore what this means for asset allocation and which types of stocks in particular should do well in this Ricardian hangover.

At the beginning of every major disruptive innovation, fear, uncertainty and doubt reign supreme. Consumers are fearful of the unknown, uncertain of the benefits and doubt the durability of the innovation. But, in the end, fear, uncertainty and doubt give way to confidence, understanding and acceptance. The fund management industry is on the cusp of a major disruptive innovation.

After the recent correction, many investors are asking how to respond in their portfolios. I’m recommending clients hold on to equity exposure, even consider increasing it. Below, I run through my case.

The last few years have been good for growth stocks, but I think there is another observation underneath the surface as well. Growth and value leadership has pivoted on Fed policy the last five years.

ETF Trends reported the other day that total ETF assets under management are expected to double by 2020, translating into roughly $740 billion per year of flows into ETFs (link to story here). If we look at just equity related ETFs, the growth dynamic is easy to see.

What drives stock returns? Answering this question has been a goal of investors ever since Harry Markowitz introduced his Modern Portfolio Theory in the 1950s. Later, William Sharpe’s Capital Asset Pricing Model illustrated that the market itself is the first and foremost element in explaining a stock’s performance. However, empirical research over the past several decades has identified many other effects beyond simply the market that exhibit a strong explanatory power of stock returns.

For the last five years the European technology sector has been locked in a trading range relative to the MSCI All Country World Index (USD). Recently, however, European technology stocks have been performing quite well. On an equal weighted basis, they have been the second best performing group in Europe year-to-date.

Looking at Fed Funds futures contracts, it would appear that the fixed income market has ruled out a June rate hike but is coming back to the idea of a 2015 lift-off. Currently June fed funds future are spot on the current effective fed funds rate of 13bps. In the chart below, we plot the current effective fed funds rate, the rate implied by the June 2015 fed funds futures contract and the 10 year US Treasury Bond. Since the June contract rate and the current rate are the same, it suggests the markets have completely moved past a June rate increase.