Anticipating Bear Markets with a Multi-Disciplinary Approach
Selling equities to avoid losses during market declines is controversial. Advocates call the strategy “tactical asset allocation.” Critics disparage it as “market timing,” often citing support for their criticism from numerous academic studies. Many advisers acknowledge the criticisms of market timing, but still advise clients on tactical asset exposure.
In a recent Key Private Bank study, we found strong evidence that a disciplined approach to asset allocation can meaningfully reduce portfolio risk. To avoid costly errors, however, both economic “fundamental” data and market “technical” indicators should be considered before making allocation changes.
Fundamental Information: The Economy
Many investment advisers base tactical recommendations on fundamental data such as economic data and corporate earnings. Historically, most bear markets – declines of 20% or more – have occurred in association with recessions. Our study showed that odds of a 20% or more decline in equities over the next 12 months rose to 90% when economic conditions were weak, and equities declined at least 10% the remainder of the time.
The downside to waiting for clear signs of economic weakness is that market declines usually start months before economic weakness becomes fully apparent. Over the period studied, the S&P 500 Index peaked, on average, more than seven months before recessions began. Between market peaks and the onset of recession, the market declined almost 9% off the top.
Thus, waiting for outright signs of economic weakness reduced the advantage of the timing signal for tactical allocation. We know, however, that economies tend to lose strength gradually as they slide toward recession. Using waning economic strength as the signal for tactical changes improved its effectiveness. Historically, clear signs of waning economic momentum appeared roughly two months after markets started to decline, when prices had fallen only 2.1% off the peak.
Unfortunately, although making tactical calls earlier improved the timing of the signals, the revised method also recorded 2.5 false signals for each accurate one. The advantage of accurate timing calls would certainly be reduced by any cost of buying exposure back after false signals.
Technical (Market) Information
Another type of information considered in tactical allocations analyzes the movement of asset prices and other market-based measures. “Technicians” believe that meaningful fundamental changes are telegraphed through market reactions, even before changes become evident in the fundamentals.
Over the period studied, technical indicators accurately identified each of the major bear markets. Notably, the technical warnings occurred an average of approximately two months after the S&P 500 peaked and roughly 2.5% off the top. Thus, the timing of the technical signals was essentially the same as the timing of signals generated by waning economic momentum. Additionally, as with the economic measures, the technical indicators also registered approximately 2.5 false signals for each correct one.
Combining Indicators for More Effective Tactical Allocation
Theoretically, combining the signals from separate flawed measures can eliminate some of the error in the individual indicators. That is precisely what our study found: combining economic and technical information eliminated 80% of the false signals without major changes in the accuracy or the timeliness of the correct signals. Slides toward significant declines in the financial markets were reflected in both sets of indicators – fundamental and technical – whereas the separate indicators each created unique false readings. Clearly, economic and technical information each helped control portfolio risk, but the combination of economic and market indicators provided reliable signals without as many false warnings.
Critically, too, an effective tactical discipline does far more than simply warn of impending declines. Historically, when both the economic and technical indicators were strong, market losses of 20% or more occurred only 1.9% of the time over the next 12 months. And more than 75% of the time, there was less than a 7% chance of a 20% or more loss over the next 12 months. As important as it is to know when to be defensive, it may be equally important to know when the odds favor more-aggressive exposure.
What We See Today
We have reached the point in the current economic cycle where anxieties about inflation, interest rates and other threats to growth will likely increase. That should also generate more market volatility. Rising anxiety and higher volatility will make it increasingly tempting to reduce equity exposure.
But the economic and technical readings do not suggest we should become defensive yet. Especially if the next recession does not occur before 2020 or 2021, as many economists believe, equities could remain a better investment than bonds or cash for some time. Until economic growth moderates and technical conditions deteriorate more significantly, history suggests that investors should lean against the anxiety of negative news and increased market volatility by continuing to emphasize equities.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.