Students help plan investment strategy by designing new economic index
Last fall, nine months after the COVID-19 pandemic began sweeping across the globe, T. Rowe Price asked students at MIT to weigh in on what the crisis would mean for the stock market. COVID-19 cases were on the rise, unemployment was up, but after an initial dip in the spring, the stock market had rebounded, ending the shortest bear market in history. This mismatch between what was happening in the real economy and in the stock market prompted the question: to what extent had the stock market become disconnected from the real economy in the United States and globally?
Eight students in MIT Sloan's Proseminar in Capital Markets/Investment Management teamed up to address this question, providing an analysis that T. Rowe Price plans to incorporate in their investment planning going forward.
“The team’s analysis was very well received by our Asset Allocation Committee. Their work had a real, immediate impact on our investment discussions,” says Sébastien Page, head of Global Multi-Asset at T. Rowe Price.
Applying tools learned in class to projects for real-world host companies is a hallmark of MIT Sloan’s Action Learning labs, which emphasize the institute’s philosophy of “mens et manus,” or learning by doing. In this semester-long course, students work with finance companies to research and address thorny questions such as the one posed by T. Rowe Price.
“The problem that we worked on was very relevant,” says Raj Kumar Anand, MFin ’22, noting that everyone last fall was wondering about the disconnect between the market and the economy. “It was not like we were just doing theoretical research.”
Developing the new economic index
To assess the interplay between the market and the economy, the students began by developing their own economic index—a totally new tool for measuring the real economy. This index was based on a variety of economic indicators that measured industrial production, employment, personal consumption expenditures, and sales from manufacturing and trade. The students then employed principal component analysis (PCA) to reduce the number of variables and create a manageable data set.
“What the students did was pretty creative and innovative,” says faculty member Mark Kritzman, who is also the president and chief executive officer of Windham Capital Management and a senior partner of State Street Associates. In addition to performing the PCA, the students created a regression model of expected stock market behavior and used a technique called residual analysis to ground that model in real data. “The methodology and the way the students applied it was all pretty new to the company. So, I believe T. Rowe Price will carry on with those techniques in other applications.”
Reconciling Wall Street and Main Street
Fabian Mertes, MFin ’21, another student on the project, says he enjoyed the course because it gave him the chance to put lessons from this and other MIT Sloan courses to work for a real organization—the central feature of all MIT Sloan Action Learning labs. For example, he says, “PCA was something that I picked up in several courses, so it was pretty cool that we could use that in our project to construct our economic index.”
“I had exposure to different quantitative methods, but what really came out of this class for me was to use them in a correct manner,” Anand says. “It was a great learning experience.”
The project team, which also included Luigi Camilli, MFin ’22, Wenyang Jiang, MFin ’22, Sergio Moya, MFin ’22, Pataraporn Peechapol, MFin ’22, He Pan, MFin ’22, and Katherine Riley, MBA ‘21, also dove into history to explore the links between the performance of the economy and the stock market. They examined such economic shocks as the oil crisis of the 1970s, the 1982 recession, and the dot-com bubble of the 1990s and found a pattern: typically, the stock market experienced an initial large crash and then recovered, eventually building to a high peak.
The team concluded that the stock market was not likely to return to bear territory as a result of the continuing COVID-19 crisis. The students wrote: “We expect that the reconciliation between Main Street and Wall Street will be driven by a robust economic recovery rather than a drop in the stock market. Our recommendation to investors is thus to not get out of stocks and, for the time being, not to enter short positions on stocks with large, positive exposure to systematic risk.”
As Kritzman explains it, T. Rowe Price was concerned that the gap between the economy and stock market performance would lead to a stock market correction. “The students were able to show that, most of the time, it was the economy that improved to catch up with the stock market,” he says. “I think that was a real surprise to the company, and I think that is the insight that caused them to actually change the way they're going to invest.”
T. Rowe Price was extremely impressed by the students’ work, which offers a new way of looking at the market in the future, Kritzman says. “The tools are the tools, but the students actually organized the tools in a novel way to generate the results that they did. I think that's something that T. Rowe Price will probably lean on going forward.”
Students gained valuable new perspective as well. “I learned quite a lot from dealing with a fairly unstructured problem,” says Mertes, adding that he also gained useful experience from working with a large group of people with very different skill sets. “It was challenging to structure the team in a way that everyone could contribute to the outcome of the project.”
Such challenges are fundamental to the Action Learning pedagogy, which aims to give students a taste of on-the-job experience. “These projects are not just about the content of the project, but about how a group of people come together to solve a problem,” Kritzman explains. “This is the way it works in industry.”
Beyond advancing his problem discovery, collaboration and analytical skills, Anand has gained an additional benefit from the class: an internship. “I got my internship because I explained how I use these techniques in such a correct manner,” he says. “My future employer was impressed by that.”