Big bears or baby bears?

This period of unusual volatility will separate investment managers from just asset gatherers…with risk management expertise being key.

— Mohamed El-Erian

I saw the above quote on LinkedIn this past week. It hit me as the perfect description as to how I would describe the difference in what my team attempts to do and what our portfolio managers at Manulife Investment Management endeavor to do on a daily basis on behalf of our clients — that is, manage risk, stay disciplined to our respective processes, and work to achieve our clients’ objectives. In other words, we fulfill our roles as investment managers.

I responded to the post with the following comment:

The easiest thing in this business is to always be bullish and hold to “buy the dip.” The probabilities suggest we would be successful 70% of the time (equities are up approximately 70% of the time over a 12-month period, as measured by the S&P 500 Index since 1927).

The hardest thing to do is to sell, take a profit and forgo further gains because the fundamentals just ain’t so. Holding to your process and letting the fundamentals be your guide is the true difference between being an investment manager or an asset gatherer. It is the difference between great and mediocre. Which would you rather be?

If we establish that this is a recessionary bear market and if we are avoiding the buy-the-dip mentality that has permeated (and admittedly rewarded) investor behavior over the past ten years, then we need to consider at what level from the peak should we start considering adding back to equities, assuming the fundamentals are supportive, of course.

To examine this, we took a look at past recessionary bear markets and segmented returns 1, 2, and 3 years following equity declines of 10%, 20%, 30%, 40%, and 50% from the peak. The following heatmap identifies the buying opportunities in each period. What we notice is that, in deep bear markets (2008–09, 2000–02, and 1973–74), the true buying opportunity (whereby gains were had 1–2 years out) didn’t occur until equities were -30% or more off their respective peaks. In shallower bears (1990–91, 1980–82, and 1970), the buying opportunity came sooner, following drops of 10%. We believe this is likely to be a deeper or big-bear market, as mentioned above. As such, the table below highlights that, during recessionary bear markets, it is prudent to wait and not simply rush into the market at the first dip. The real payback appears to occur when equities are down 30% or more.

Lastly, we need to attach realistic timelines to the equity market recovery. There is a belief that equity markets will rebound quickly following a resumption of normal economic activity. I have even heard some speculate that the market can reach its prior peak by year end. We are not of that belief for two reasons. First, we would argue the fundamentals didn’t justify markets being at the February levels to begin with; therefore, a return to overvalued levels is less likely. And second, from a historical perspective, a sharp equity market rebound is rare. Market commentators like to attach letter shapes to the economic or equity market recovery — I have heard of V, U, W, or L-shaped recoveries. While we don’t subscribe to these definitions, if we had to, we would say the equity market recovery might look like a V that has lost its energy — that is, a sharp decline met by a flatter sloped recovery, or rather, a longer-dated and gradual pay-back period. Investors would be wise to keep this in mind when setting expectations.

We highlight how long it took for investors to break even on their initial investment once the markets had bottomed during previous recessionary and non-recessionary bear markets. The chart below illustrates the median and average trading days it took for an investor to break even after investing at drops of 10%, 20%, 30%, 40%, and 50%. For example, after a drop of 10% from the peak, on average, it took approximately 730 trading days to break even from a recessionary bear market versus 138 in a non-recessionary environment. There are approximately 250 trading days in a year, so this suggests an investor who bought at the first 10% dip during a recessionary bear market may not see a return on that investment for almost three years.

We believe the conditions are consistent with a recession and, as such, would put this bear market into the recessionary camp. Markets don’t move in straight lines; we should anticipate bear-market rallies in prolonged dislocations subsequent to which old lows will either be retested or broken. We should also be realistic about the recovery period for stocks. During the dot-com crash, we experienced six different bear market rallies (a rally of greater than 20%) within the ultimate pullback of 49%. Too many believe we will recover by the end of the year. History doesn’t show that. But what it does show is that from these levels, investors do see gains 1, 2, or 3 years out.

It is for these and other fundamental reasons that we are starting to hold equities in a more optimistic light. And while we still maintain an overall underweight to equities in our model portfolio, as of this quarter, we are starting to take advantage of the price dislocation and have shifted 5% from fixed income to equities. Our current model portfolio asset allocation, as at the end of the first quarter, now stands at 55% equities and 45% fixed income. The opportunities are not without a cost. At this time, we believe the cost is patience. We also believe that patience will be rewarded.