“History doesn’t repeat itself but it often rhymes,” the American writer Mark Twain once said. In fact, a look back at history often reveals much about what the future may bring. Findings gleamed from 200 years of US equity market history should provide some clues, not be used as forecasts.
From our standpoint, past bear markets can be divided into three types: cyclical, structural and event-driven. Textbook cyclical bear markets act as a balancing movement after central banks prevent the economy from overheating, which ultimately culminates in recession. On average, the downturn lasts for around two years, recovery about four and the loss in value comes to around -30%. Structural bear markets follow a system collapse such as that seen in the 2008 financial crisis. The downturn lasts for around three and a half years on average, recovery about 10 and the loss in value comes to just under -60%. It is typically slow to recover from its slump. Event-driven bear markets are triggered by a decisive event such as a war or a pandemic. Because these events can vary significantly, only limited conclusions can be drawn about future trends. On average, event-driven bear markets also involve value losses of around -30% but the downturn persists for only around nine months, with recovery taking 15 months. The sudden slump usually is followed by relatively rapid recovery.
The coronavirus crisis has the world in its grasp. Equity markets’ massive response over the last few weeks to the highly unsettling event can be compared to the stock market crash in 1987 but not to the onset of the financial crisis in 2008 (structural) or the Great Depression in 1930 (cyclical). The correlation between equities and bonds is more or less the same as seen when the Internet bubble burst in 2001. Economic leading indicators are pointing to a downturn. Central banks have once again relaxed their monetary policy and announced bond-buying programs. Governments are introducing fiscal policy stimuli and providing wide-reaching rescue packages, including now in the US. The number of infected is continuing to climb, with the pace of this increase especially rapid in the US. This is contradicted by signals from Google searches, which suggest that the situation will soon reach a turning point. The ratio of puts and calls is the same as in the 2008 financial crisis, with volatility also as high as it was then.
Once panic sets in, many investors rush into hasty decisions to secure their finances. This is not the approach taken by the Vontobel Fund II – Vescore Active Beta, which is based on quantitative models. The machine behind the fund uses daily data inputs. It is designed to make impartial tactical investment decisions, independent of human thinking and underpinned by systematic risk monitoring. The multi-asset fund invests primarily in equities and government bonds around the world with the goal of participating in growing markets and achieving steady growth in the long term with a volatility target currently at 5.5%. The share of equities and the duration are adjusted in line with current market conditions on an ongoing basis. Two established and independent Vescore models are used to measure long-term investment opportunities and associated risks in the fundamental macroeconomic environment, with one model for equities and one for bonds. At present, the maximum equity ratio is 60% and the maximum duration is 10 years.
The equities model uses the following key indicators, which are based on market data, as input factors: term spread, TED spread, credit spread and dividend yields. These data sets record long-term economic expectations, market player confidence in companies, liquidity preferences for different currencies, systemic risk and fundamental stock valuation. Using this data, the model calculates optimal equity allocation on an ongoing basis. Currently, this ratio ranges from 0% to 60% and is divided equally between the three regions of North America, Europe and Asia/Pacific.
The fixed income model’s market traded input factors are carry, mean reversion and momentum. These sets of data record current yields, the effect of mean reversion, and momentum on the bond market. Using this as a basis, the models indicate the best duration allocation. This currently ranges from between 0 and 10 years, with the bonds weighted according to the signals.
The risk management integrated into the investment process is based on a risk indicator that measures the probability of a high risk in future on an ongoing basis. This draws on data sets covering market turbulence across different investment classes. It is designed to respond relatively quickly to changes on global financial markets, aiming for a reduction of risk exposure at an early stage in particularly high-risk periods to lower loss potential and make the fund value less volatile.
The models used by the Vontobel Fund II – Vescore Active Beta look at the latest market conditions every day to determine the optimal equity allocation and duration for the portfolio. They each require three to four weeks to process the latest economic variables. In the last month, the equity quota has slimmed by 25 percentage points to 31.5%. The term spread and the TED spread components gave negative signals and the valuation component a positive one, bringing the equity ratio to slightly above neutral (30%). The duration remained more or less unchanged at 2.3 years, split into Euro, US-dollar, Canadian dollar, and British pound. The carry and momentum components sent a slightly positive signal whereas the mean reversion component a negative one. Since the start of the year, the risk indicator has been showing an increased to high probability of high future risk. The fund has declined by -11% in value since the start of the year. Equities accounted for roughly -12%, of which the bond portion cushioned +1% as a risk buffer.
We implement our active strategy using futures, which we believe allows us to save on transaction costs and trade at any time thanks to high liquidity. The latter is especially crucial in times of crisis, as the distortions on the lending markets show. We hold cash as the basis for futures positioning only in short-term bonds with very high credit ratings because security and liquidity are our top priority. Our investment approach has proven successful since the fund was launched in 2002, as illustrated by the average performance of 4% p.a. seen since launch. We are convinced that our models are stable: not only in bear markets but also during recovery, which we hope to see soon.