united kingdomen
Navigating the two-way risk in equities

Navigating the two-way risk in equities

03-04-2020 | Monthly outlook
Investors are facing an unprecedented conundrum about whether equities have bottomed out, our multi-asset monthly outlook says.
  • Peter van der Welle
    Peter
    van der Welle
    Multi-Asset Strategist

Speed read

  • Key valuation metric suggests additional downside risk remains
  • Bounces of over 10% are the hallmark of enduring bear markets
  • Bears may be waiting though for a trough that already occurred

Panic over the coronavirus and the resulting market meltdowns have sent many abandoning stocks to seek the relative safety of government bonds or even credits.

However, bears may be waiting for a trough that has already occurred, says Peter van der Welle, a strategist in Robeco’s multi-asset team. It presents a ‘two-way’ risk for investors before more clarity is available, he says.

“The fastest slide of equities into bear market territory since 1929 evidences the unprecedented uncertainty surrounding the external shock to the global economy posed by the coronavirus,” Van der Welle says. “This has been aggravated by the sudden change of tack by OPEC+ in the oil market.”

“Although implied equity volatility has fallen from levels even exceeding the peak of the 2008 global financial crisis, visibility remains low, with equity volatility still around four times the historical average.”

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

A real recession threat

The coronavirus is almost certain to usher in a recession, though the unique circumstances of lockdowns to prevent Covid-19 spreading means few have any idea what kind of economic damage – and any subsequent recovery – might result, he says.

“Although unprecedented levels of fiscal and monetary stimulus may very well dampen the downturn, solving the health crisis first is key in order to obtain some clarity on the most probable economic recovery path,” Van der Welle says.

“Yet, as investors we are not rewarded for waiting until the dust has settled, and the macroeconomic view becomes clearer. In confusing times like these, market technicals trump fundamentals in market pricing behavior. With major equity indices down more than 25% from the recent highs, the natural question is: how much downside in indices is left from a technical point of view?”

Hopes of bottoming out

He says hopes that equities have bottomed out have risen following a record daily bounce of 11.45% on 24 March ahead of the USD 2 trillion stimulus package announced by the US Congress – but the market may still be in the denial phase.

“A daily return for the Dow in excess of 10% is extremely rare – it has only happened eight times since 1900,” says Van der Welle. “And it is not necessarily good news when put into a historical perspective. With the exception of post-trough moves in September 1932 and March 1933, all jumps in excess of 10% typically happened fairly early on in the bear markets around the Great Depression, the Great Financial Crisis and Black Monday 1987.”

Source: Dow Jones, Robeco

“The first bounce of more than 10% in the 1931,1987 and 2008 bear markets was still followed by another wave of selling before the final trough emerged. From a sentiment angle, recent exceptional bounces suggest that investor sentiment is still in the denial phase, rather than in the phase of capitulation that paves the way for a new bull market.”

“By now, equities, high yield and investment grade bonds have fully priced average recession risk. However, the average recession does not exist, and this recession won’t likely fall into this category either, so we have to be more granular.”

The devil is in the detail

What matters most for market timing purposes is not the ‘average’, but those kind of granular details, Van der Welle says. One good question to ask is: what were the specific preconditions under which this bear market emerged?”

“We find that the best variable to explain the variation around the average peak-to-trough returns for the S&P 500 Index is the Shiller CAPE (the Cyclically Adjusted Price/Earnings ratio) at the prior market peak,” he says.

“Allowing for the fact that we’ve had a historically high starting CAPE (31) at the February S&P 500 Index peak prior to this sell-off, the remaining downside in the S&P from the current index level is still more than 10%. The CAPE tells us to keep an eye on downside risk, as it could still be lurking in a corner of this bear market.”

Not out of the woods

So, is the worst over? Not necessarily. “Low visibility on the macro front, a state of denial in investor sentiment, unpredictable bounces of 10%+ and stretched US valuation levels are important clues that we might not be out of the woods yet,” Van der Welle says.

“However, the risk for bears is that they are waiting for a trough that already happened. External shocks like the one experienced in recent weeks typically trigger shorter recessions and sharper recoveries, which markets quickly anticipate.”

The unprecedented stimulus of central banks and increasingly of governments will be a factor in how long a recession lasts. Although economic activity will likely normalize on a 12-month horizon, these are testing times, and it is uncertain which side tips the balance for equities in the near term.”

Two-way risks remain

“There is therefore obvious two-way risk for equity investors at this juncture, which leaves us preferring to adopt an overweight in credits and high yield bonds instead of equities to position for the eventual economic recovery.”

“These asset classes are increasingly bought by central banks, they tend to lead equities in the business cycle, and have sold off more than was warranted for average recession risk, which makes them relatively better value now than equities."

Subjects related to this article are:
Logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree