Artful Trader

Which asset classes outperform in a market downturn?

First, let’s start with the bad times, previous market downturns. In the chart below, we evaluate the 10 worst months in the S&P 500 since July 1986. US stocks averaged a negative 11.8% return in those months. 
 
The worst month, of course, was October 1987 when stocks fell 21.5%, ouch! And by the way, if you extend this analysis back to 1900, the average decline of the worst 10 US stock market downturn months is closer to negative 20%. 
 
In the below table, we include some of the main global asset classes. What you’ll find is that there’s a wide discrepancy in the extent to which the asset classes held up – or didn’t – in nasty, downturn months for US stocks.
 
For example, note how a few asset classes performed equally bad during those times, including foreign stocks, commodities, and real estate investment trusts.
 
Also observe how Treasury bills, 10-year government bonds and gold performed. We’ll comment on those below.

Treasury bills had a great batting average, positive in all 10 months, but offered little diversification benefit with average returns of 0.2% in those 10 months.

10-year government bonds were slightly better, with average returns of 0.8% but only positive in six of ten months. 

Gold had similar returns of 0.8% and a good batting average of 80%, but also had a terrible month, falling 16.9% to coincide with the second worst stock return month, which was negative 16.8%. So, hedging is not guaranteed.
 
Let’s see how all of these various investments performed during longer periods, namely the two big bears in the US since 2000. These bears saw brutal declines of 42.5% and 50.9%. 
 
In the table below, notice how foreign stocks had equally bad performance as US stocks. Commodities and real estate investment trusts held up during the first bear but collapsed during the second. 
 
Treasury bills had positive, but muted returns, and gold shone nicely. US 10-year bonds also had nice returns of 29.6% and 18.2% across the two bears.

So clearly, some of these asset classes did help in market downturns.

 

How a negative market impacts investors and financial advisors 

If you’re an investment advisor watching today’s market, you might be feeling especially nervous. That’s because stock market downturns have a leveraged, intensified effect on asset managers and financial advisors, far more than many realise.
 
 
Advisors have exposure to the stock market through:
 

- Their personal portfolio – obviously, a bear market will erode the value of the advisor’s own portfolio.

- Their shorter-term business revenue (i.e. client portfolios) – a bear market will decrease the size the advisor’s total book (client market cap), resulting in less revenue spun off from the smaller asset base.

- Their longer-term business revenue – lengthier bear markets will result in some clients panicking and withdrawing their investments entirely, which could permanently shrink the advisor’s book.

- If the advisor is an employee of a parent company, he/she risks potential employment termination due to downsizing.

 
You can view some of the correlated effects in the two charts below. These charts highlight the revenues (Figure 16) and stock prices (Figure 17) of a number of representative asset managers that still exist today. 
 
While some asset managers may have weathered the global financial crisis and posted more positive results, we believe the below list to be representative of some of the largest asset managers that survived the global financial crisis. 
 
Also recall, many asset managers like Lehman Brothers and Bear Stearns didn’t survive the global financial crisis and their stock prices and revenues saw declines of catastrophic levels.
 
Revenue for asset managers in the global financial crisis declines across the board.And not surprisingly, their stocks take a hit.
 
And while the revenues and stock prices of these large asset managers eventually recovered, it shouldn’t be assumed that all asset managers - especially small to medium-sized shops - can simply ride out similar challenging markets.
 
Simply put, a falling stock market negatively impacts only the investment portfolio of the average individual investor. Yet for advisors, it impacts their personal portfolio, their shorter-term business income, potentially their longer-term business income, and in dire situations, the viability of their company. 
 
Many investors can reduce their equity exposure, but many advisors and investment companies cannot.
 
Given this heightened sensitivity, it may be more appropriate for an advisor to purchase a tail risk strategy, therein hedging its business revenues, than it might be for the average individual investor.
 
 
 
This is part two of a four-part series on how best to implement a tail risk strategy in an ageing bull market. 
 
By Meb Faber, who is the co-founder and chief investment officer at Cambria Investment Management, and creator and host of The Meb Faber Show podcast. He is the author of 'Invest with the house: hacking the top hedge funds' and 'Global asset allocation: a survey of the world’s top investment strategies.'

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