Real Returns by Dan Mikulskis

Reading Time: 9 minutes

No plan survives first contact with the enemy

Herman Von Mutke the Elder

During a speech in November 1957 Eisenhower told an anecdote about the maps used during U.S. military training. Maps of the Alsace-Lorraine area of Europe were used during instruction before World War I, but educational reformers decided that the location was not relevant to American forces. So the maps were switched to a new location within the U.S. for planning exercises. A few years later the military was deployed and fighting in the Alsace-Lorraine.

His point was to illustrate the truth of the apparently paradoxical statement: Plans are worthless, but planning is everything. 

There is a very great distinction because when you are planning for an emergency you must start with this one thing: the very definition of “emergency” is that it is unexpected, therefore it is not going to happen the way you are planning

Dwight Eisenhower

The shock phase here is over, it’s time to get back to the plan.

Remember, a slower market recovery has upsides, too

If you’ve read half as many Q1 investment reports as I have you won’t need me to tell you that we’re in “unprecedented” times. Markets crashed to crisis-like stress levels with record-breaking speed, and funding, liquidity pressures have driven price dislocations similar to 2008, 1987 and WWII. But that all feels like a long time ago now. (If like me you enjoy playing silly jargon bingo on investment reports, check out my Q1 bingo card here).

The S&P has rallied over 20% almost in a straight line since the volatility peak of March 16. So is this a Black Swan, Fallen Angel or Dead Cat Bounce? When you are short on answers, sometimes the best we can do is keep asking the right questions.

The investment discussion seems to me to have moved on a little though, last month I wrote on three questions we were all asking at that point –

When will the bear market come to an end? How long will it take to recover?Will the market bounce straight back?

We still have questions, and few answers, but I think we’ve moved the conversation on from “when will it stop” to “what next”.

Beware the narrative of “the worst is behind us” – strap in for a longer ride

Bear markets usually last a lot longer than this (c24 months on average to go from peak to trough, 9 months if looking only at “event driven” bears – say Goldman in their “bear essential” study for more info).

And historically it takes as least as long again to get back to the previous peak. The market peak was mid-Feb so at the time of writing we are not yet even 3 months in to this decline. We may well have seen the bottom at this point but historical odds are not on our side. Our base case should probably be that we need to wait longer both for the eventual bottom, and the recovery. But things are happening faster than almost ever before, and what do I know?

The fastest bear markets in the Goldman study were the 3 months it took in 1990 for the S&P 500 to decline 20% (4 months to recover), the 3.3 months in 1987 and the 6 months to fall 28% in the second half of 1962. The recovery times were 4, 20 and 14 months).

It’s easy to forget but in what turned out to be the opening chapters of the 2008 crisis, Bear Sterns was taken over in February 2008, with the S&P 500 already down almost 20% from the highs. At the time the pervading narrative was that the worst was behind us, which turned out not to be true. But it shows how powerful that particular narrative is, and how dangerous as we fall for it again and again, because of course we are optimists by nature and pain in the past looms far less large than potential pain in the future.

It is worth keeping in mind that if history is anything to go by, we’re still in the early stages of an event.

Let’s turn to the big questions I think we’re all asking today –

Has the Dust Settled?

Will the winners keep winning?

What about Defaults?

Has the dust settled?

Despite the metaphors we like to use, markets don’t behave like physical systems unfortunately, nice as that would be. We don’t know that “the dust has settled” until well after the event, and what does that even mean anyway? But again, I do think history can set a useful baseline for our expectations. PGIM have a good piece looking at the history of volatility spikes, and the behavior after these peaks. They analyse 25 occasions since 1950 when volatility peaked. They looked in detail at what happened next.

A decline in the VIX of one third from the peak was set as representing the “dust having settled” after a volatility spike. A bit arbitrary perhaps, but you have to start somewhere. The time taken for this decline to happen historically is remarkably consistent at around 7-9 months, and doesn’t vary much with the size of the initial spike. At the time of writing the VIX is back under 40, compared to a peak of 83. It had fallen by a third by the end of March, just two weeks after the peak.

The PGIM researchers looked carefully at the returns in the different periods and draw out a few averages:

• The VIX volatility index takes on average 9 months to decline by a third (and stay there) with the fastest decline recorded being 5 months – in 2004 and twice in the 1970’s. So far it has declined far faster than that, but has it stayed there? We only know that after the fact of course
• Market returns in the period in which the VIX is falling back from it’s peak tend to be low and volatile, with an average return (S&P 500) of pretty much flat in that period of time – notable exceptions being in 1998 when it was up 25% in that time and 1982 when it was up 39% in that time.
• Stock market Drawdowns are common in the period as VIX is falling from its peak, average drawdowns were over 10%, with 17% in 1987 ad 25% in 1974, so far the S&P is up 20% since the March 16 VIX peak, and hardly dropped into negative territory since then. Recoveries don’t tend to happen in a straight line, but so far this one has

We’re in unprecendeted times, as you know by now, so there’s a limit to the relevance of the historical comparisons. But they are useful for setting out a sensible base case for how extreme market moves play out, and right now the historical comparison is telling us to expect further market falls, and a longer period before markets recover. As Ben Carlson notes, it’s entirely possible that really confusing things happen like we get further stock market falls on the back of good news like the announcement of a vaccine.

Great if the recovery happens quicker than history, but investors would be wise to base their expectations on the historical comparisons and plan accordingly.

In the meantime, there are upsides to a slow and volatile recovery which are often underappreciated:

• More time to plan rebalancing into growth assets and assess/allocate to opportunities
• More opportunity to average in ongoing savings / contributions into cheaper market levels
• more opportunity to re-invest dividends and other income into cheaper markets

What about defaults?

Away from equity markets, much commentary has focused on the sharp increase in credit spreads, with parrallels drawn to 2008. I’ve lost count of the number of times I’ve heard the words “fallen angel” recently.

The covid19 pandemic has led to a huge economic shock which has spared almost no sectors, and could quite conceivably put a serious number of companies out of business, so that’s why the yields on corporate bonds have shot up to the highest levels in the last decade with US high yield bods yielding above 8% p.a.

Many companies will make it through and re-pay their bonds at these high rates offering investors good levels of return. That’s why many advisers, including LCP (you can listen to our latest views here) and wealth manager UBS are guiding clients toward credit allocations as the best risk/return investment opportunity for portfolios – as things stand equities appear to be pricing in pretty close to a central scenario as to how things might pay out, but credit appears to be pricing in a downside scenario. Sure, not every company will survive, so you will get some defaults, but that’s why we use diversified portfolios, and we’re being paid a good yield to compensate for the risks.

One reason why credit is a good investment coming out of a crisis is that when yields get very high (say abouve 8% p.a. for high-yield bonds) you start earning yourself a nice healthy return straight away, whatever happens to the underlying markets. Equity markets can fluctuate around for years without going anywhere whereas credit markets start paying you a handsome return straight away, through income and then maturity payments, which cushions further falls. Coming out of 2008, lower-quality bonds were the best risk-adjusted return asset for many years, for exactly that reason.

The problem is defaults, these are the enemy of any credit investor. Deutsche bank produce an in-depth report, which was well written up by john Authers. Deutsche reckon current levels are consistent with default rates of around 40% in US and European high-yield bonds, compared to rates of 20% implied at the start of the year, and a current rate over the last year of around 5%. We’re at levels only seen in 2008 and the great depression, so there’s a lot of bad news priced in there. So credit risk is certainly perceived to be elevated, but the market has a history of overshooting, in both directions.

Will the winners keep winning?

Coming out of a market crash the question is often whether the pre-crash market “winners” (in this case tech stocks like FAANGS, and the growth, momentum strategies they feature in) will contine to dominate or will the previous losers (value stocks, banks, oil companies and regions like the UK and Europe) play catch up in the recovery as a rising tide lifts all ships?

That question is particularly pertinent to UK equity investors right now. They might well be scratching their heads here as the portfolio is telling them two different stories at the same time.

Their holdings in US, or global equities will be down only modestly (perhaps 5-6%) since the start of the year, thanks to the very strong rebound seen in US equities, and the role of dollar exposure in cushioning equity falls as sterling fell in value.

UK equities on the other hand have not enjoyed the same bounce as US equities, and remain down around 20% year-to-date, which is similar to other European equity markets – see below – all in local currency (source: Koyfin). Active UK equity investors may have fared even worse as the mid-market FTSE 250, which often features in active portfolios has underperformed the main FTSE 100 market.

There are a number of reasons for this including Brexit, and the dominance of oil, and lack of tech names in the UK equity market. These were themes that were in play before this crisis and have continued.

European markets including the UK have shown up as better “value”on a price earnings basis for years, but that opportunity has only got better and better, also known as the trade losing money. Value equities right now have never looked better value compared with growth, but is that an opportuity or a danger? As always in markets two different interpretations is what it takes to make a market.

Interestingly PGIM’s work suggests that volatility spikes on average tend to reset the winner/loser dynamics that were in place pre-spike, with everything rallying together post-peak. It’s not what we’re seeing yet this time around but, plenty of value investors are expecting it.

What next

As conversation turns to what’s next, all eyes are on the loosening of lockdown restrictions, how this works and how long it’ll take. That seems to be by far the most significant thing that economists and strategists are tracking at the moment. One thing that is interesting this time around, is the volume of high-frequency new data sources we’ll have to track the recovery in the service economy – everything from actual foot traffic to opentable data – check out Jim Bianco’s blog for more of these. Early data from China shows that re-opening is far from business-as-usual. With so many variables and so little to go on, one irony is that at the point where demand for forecasts is highest, our ability to forecast is at its lowest. With this in mind, investors would be well served in trying to resist the temptation to time markets and the temptation to double down on underperforming sectors and countries.

As for the longer term? That’s probably a conversation for another day. There is the question of inflated budget deficits, money-printing and if/when this would ever lead to inflation (the economist had a good piece on this). We could well be looking at a world that is more indebted, less global and more digital. The question will be how best to invest in that world.

Personally I’m worried about the increasing effect on inequality that this all has – waiters, cleaners and builders have lost jobs and in many cases been pitched into very precarious financial situations while consultants and lawyers can sit around in their pyjamas earning the same as before while tweeting top working from home tip,s writing blogs, gardening and learning the piano.

History suggests we’re in this for some time yet, but that isn’t necessarily a bad thing. Investors can do themselves a favour by setting expectations based on historical guides, and trying to manage their classic behavioral biases: to avoid loss, time the markets and control things that can’t be controlled.

It’s a truism that no plan survives first contact (or as Mike Tyson so eloquently and memorably put it “when you get punched in the mouth”). We are probably past the punch in the mouth phase of this episode, and a lot of plans might have been thrown in the dustbin, but what next? Investors would be wise to also bear in mind those sentiments of Dwight Eisenhower when he said “plans are useless, but planning is essential”, and start focusing on their plan from here.

The details of a plan which was designed years in advance often turn out to be incorrect or are overtaken by events, but the planning process demands the thorough exploration of options, contingences and a focus on the objective. The knowledge gained during this probing is crucial to the selection of appropriate actions as future events unfold, however unexpectedly.