Using cash to manage risk and create alpha
By Will Hubbard, CFA
When I was 16, I worked in a local greenhouse and saved as much money as I could to buy a car. The cost of buying a car also included the steep cost of insurance, which was especially expensive for a new driver. Fortunately, my parents were willing to help me out with that. Although it was nothing special, I really enjoyed having that car to drive to and from work and buzz around our small town with friends.
It wasn’t until I had been driving for a few years that I found out what it was like to be in an accident.
My car was the third car to be hit in a five-car pileup. It wasn’t a bad wreck, but my car was totaled, and I was mentally shaken. The images right after being hit are permanently seared into my mind. I was fortunate it wasn’t worse. At that point, I learned two things:
- Accidents happen in the blink of an eye, faster than anyone can do anything about.
- The value of insurance—of managing risk—is immense.
The perils of complacency
It’s almost hard now to remember what a market crash feels like. Markets are in one of the longest bull markets in history (depending on how you measure it), and economists don’t expect another recession for some time.
The phrase “breaking news” flashes across the screen when markets are down a percent or two for the week. Watch Bloomberg TV or CNBC long enough and reports of the markets’ new highs are constantly discussed, along with rosy predictions for more gains.
Although there are a few naysayers in the financial media, it’s as if the entire investing population has forgotten the pain of 2008, when the market dropped nearly 8% in a single day on reports of very poor retail sales and predictions of the worst recession since the 1980s. By the end of October 2008, the major equity indexes lost more than 10% and finished the year down just short of 40%. Accidents happen in the blink of an eye.
Accidents are fundamentally the reason insurance companies exist. Insurance companies help protect against unforeseen losses, which is akin to what risk-focused investment managers seek to do.
In a situation like 2008, minimizing losses is the most desirable outcome for almost all investors, though many professional managers will seek to make a profit in any environment. Risk managers use all of the tools available to mitigate losses, reduce volatility, and do the best possible job at following Warren Buffet’s primary rule: “Don’t lose money.”
Why cash can be both a defensive and offensive tactical tool
Some of the tools available for risk management are cash, inverse (short) funds, and options. Cash provides a stable value, short funds are a direct contrarian stance on the market at a point in time, and options can be used to provide a convex payoff curve.
The following example analyzes a strategy that tracks the crossovers of the 50-day and 200-day moving averages from February 2005 through February 2018—a period encompassing the Great Recession and one of the longest bull market rallies in history.
By applying a simple moving-average crossover strategy, risk can be effectively mitigated, reducing drawdowns and overall volatility, two things that substantially decrease the likelihood that an investor will outlive their savings.
Figure 1 shows how a simple strategy, applied historically, mitigates drawdown while also reducing some upside in times of short-term turmoil. For illustration purposes, the strategy uses an annualized 1% return for cash when the 50-day moving average is less than the 200-day moving average. When the 50-day moving average is greater than the 200-day, the return for the S&P 500 is assumed as the return.
Three things are clear in Figure 1.
First, 2008 is handled well by the cash-switching strategy. Second, the market catches back up relatively quickly as the alpha effect produced by holding cash declines. Third, the market outperforms a moving-average crossover strategy over the entire period.
This assumes investors can stomach the jaw-dropping volatility of 2008–2009. Research studies indicate this was not the case for many investors during that period—or in other times of great market stress as well.
Related to the first point, drawdowns are handled extremely well by a moving-average crossover strategy. In the case of 2008–2009, the drawdown of the S&P was 55%, while the crossover strategy experienced a drawdown of 21%. Not only did the moving-average crossover strategy reduce drawdowns, but it also decreased the volatility of the portfolio from 17.7% to 10.7%, a 40% reduction.
Now, some could argue that the strategy that moves to cash adds less value than a buy-and-hold strategy for the S&P 500. However, the purpose of active management is to smooth out the returns and reduce risk to investors through time.
In this case, the net reduction in total return between a buy-and-hold strategy and the moving-average crossover is just 7.3%. That means the buy-and-hold strategy added around 0.5% annualized compared to a risk-managed strategy such as the moving-average crossover.
Portfolio risk management is critical for retirees
Clients who are in retirement or withdrawing funds for personal reasons (a house purchase or funding college, for example) are extremely susceptible to their emotions and poor decision-making under a “buy-and-hope” style of investing.
Imagine starting with $100,000 in 2006 and withdrawing $400 per month ($4,800 per year) regardless of the market. In the depths of the Great Recession, an investor owning the S&P and withdrawing $400 per month would have seen his $100,000 dwindle to $44,000 while an investor with a cash-managed strategy would have dipped to $83,000.
By the time 2018 rolled around, the investor who adhered to a strategy that tracks the crossover of the 50-day and 200-day moving averages would have withdrawn $58,800 and would have an account value of $130,000. The investor owning the S&P 500 would have the same withdrawals but would have $110,000, almost 20% less in his or her account.
Market drawdowns negatively impact investors so severely when taking distributions that managing the downside and managing client expectations are two of the most important considerations for a financial adviser managing a client’s investment portfolio. Even for clients not taking distributions, the crossover-strategy example shows that though some performance might be sacrificed with a risk-managed strategy, the behavioral and emotional benefits of avoiding steep drawdowns arguably more than makes up for it.
Will historical drawdown levels occur again?
For years, we have been in a bull market and investors have been extremely happy with returns—so happy that complacency appears to be setting in. Memories are becoming so short that it’s easy to forget how easily 30% to 50% of savings can be wiped out.
Since 1942, investors have experienced a market drawdown greater than 5% about 34% of the time. From 2016 to early 2018, the time spent in drawdowns over 5% shrunk to 7% of the time.
Looking back by decade, the last time investors experienced a drawdown less than 20% in a decade was in the bull market of the 1990s, which was soon followed by the dot-com bubble, the Great Recession, and the “lost decade.” Figure 2 shows the worst drawdowns by decade from 1940 to the present day.
Since the Great Recession, many investors have changed course, moving from active, risk-focused strategies to a more passive buy-and-hold style of investing via index funds. Still, market corrections, just like auto accidents, happen, and they happen more often than investors realize. Yet investors have been trading in their “insurance policies” in the hope that a severe accident will never happen—and it has been working for several years.
But perhaps now is the time to shop for “insurance policies” again. Active investment managers focus on protecting client assets and minimizing the impact of steep market drawdowns by using in-depth quantitative and qualitative research and strategies to address potential market pitfalls.
Remember, accidents can happen in the blink of an eye.
Note: The opinions expressed in this article are presented for educational purposes only. The strategy mentioned in this article is an illustration of an actively managed risk strategy. The results are not represented as actual trading or client experience, and they do not reflect the impact on decision-making or economic or market factors experienced during actual management of funds. It is not meant to be used as the foundation for client recommendations or as a foundation for research into actively managed risk strategies. It is simply for illustration and educational purposes.
by Jerry Wagner
The major stock market indexes all gained ground last week: The Dow Jones Industrial Average gained 1.8%, the S&P 500 Stock Index rose about 2%, the NASDAQ Composite climbed 2.3%, and the Russell 2000 small-capitalization index was up 2.5%. The 10-year Treasury bond yield was flat last week, as were bond prices. Last week, spot gold closed at $1,557.24, falling $5.10 per ounce, or 0.3%.
Last week was a big news week. As suggested by the across-the-board gains registered in stocks, the news was almost unanimously positive.
Reports on housing, consumer sentiment, and unemployment claims all pointed to an economy that is once again expanding, crushing the pessimistic recession forecasts of a year ago. The housing starts numbers were terrific and were at the level one normally associates with a recovery from a recession, not 11 years following one. Therefore, it is not surprising that such news has normally led to stock market gains over the next year.
The consumer sentiment numbers remained at the high levels we have seen since the last election. More importantly, the unemployment claims numbers fell for the fifth week in a row. Before that, the claims level seemed to have reversed higher to the extent that it was setting off some economists’ recession alarm bells
As good as these numbers are, the best news was the blowout number recorded for retail sales. Growth went from 3% to almost 6% for the month of December.
This is almost the exact opposite of the scenario investors were faced with back in September 2018 when sales fell from just over 6% back down to under 4%. The result was an almost 20% decline in the S&P 500 over the subsequent three months. Many believe that stocks could chart still higher, reflecting the direction of the new numbers.
Such thoughts seem to be suddenly springing up from numerous sources. The fear of many seems to be that, rather than a 2018 stock meltdown, we will have a melt-up in equity prices.
Among the economic reports announced last week, a solid majority of the announcements beat economists’ expectations—which hasn’t happened in some time. While industrial production once again fell, dropping 0.3%, it was encouraging that the manufacturing reports from both the New York and Philadelphia Federal Reserve regions turned positive.
Another source of good news came in the form of monthly inflation reports. Year over year, the Consumer Price Index and Producer Price Index (excluding food and autos) came in lower than expected, while the rest of the inflation measures remained flat. This is good news for bonds, which have been in a slump, and it also supports the Fed’s decision not to raise rates.
The resulting reduction in inflation fears combined with the reduction in trade tensions, hallmarked by the signing of the phase-one U.S.–China trade deal on Wednesday, contributed to the weakness in gold. Even a continuation of the decline in the U.S. dollar and the looming impeachment trial could not move the price of gold higher.
Technically, the stock market could not be stronger. The new highs in almost all of the stock market indexes have been confirmed by most market internals, like the cumulative advance-decline line and the number of new highs by individual stocks.
With the gains registered in just the first 12 days of the year, some of the more pessimistic gurus have already hit their 3% 2020 growth target! Is this too much, too soon?
Maybe. The S&P 500 has gained between 3% and 4% in the first half of January seven times before. In the succeeding 1–12 months, stocks have advanced every time (averaging 22.4% over the rest of the year)! But we have also seen a 4%–5% increase in the NASDAQ already this year. In the past, that has led to lower returns over the next 1–6 month period and an overall average gain of just 3.8% over the rest of the year.
The market continues to be overbought, and bullish sentiment by some measures is extreme. While such conditions can continue for a very long time (see 1999, for example), when I say that the market “could not be stronger,” as a contrarian, I worry that a short-term top may be near. Still, I am not alone in those worries, and that does alleviate some of the concern.
Our Political Seasonal Index points lower, bottoming on January 27. (Our Political Seasonality Index is available post-login in our Solution Selector under the Domestic Tactical Equity category.)
Our intermediate-term tactical strategies are positively situated: The Volatility Adjusted NASDAQ strategy (VAN) has increased its equity investment position to 200%, Classic continues to be fully invested, and our Self-adjusting Trend Following strategy (STF) remains at 200% invested. VAN and STF both employ leverage—hence the investment positions of more than 100%.
Short-term indicators remain mixed. Our QFC S&P Pattern Recognition strategy’s equity exposure continues to be slightly negative.
Among the Flexible Plan Market Regime indicators, our Growth and Inflation measure still shows that we are in a Normal economic environment (meaning a positive inflation rate and positive GDP). Our Volatility composite (gold, bond, and stock market) is now showing a Low and Falling reading, which favors stocks and then gold over bonds—although all have positive returns in this regime stage.
I’m looking for short-term weakness to sideways action in stocks, but remain long-term bullish.
All the best,
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