11 February 2016

Quantifying Bear Market Risk

Executive Summary

Markets have broken January lows. After re-checking all our data, we find that stress is still isolated to the energy sector although fear has affected banks as investors fret over contagion. At this time we are not unduly worried as banks are well capitalised and can quickly reduce excessive costs. In view of the extreme pessimism, we are likely to see a rally come off the bottoms. However, we would like to check for sustainability of the advance through four factors as described in our main article. Looking at possible losses in an “Echo Bear” scenario, historical median equity drawdowns are around 19% with the cycle lasting 200 days. We could be near the end of this process. However should losses magnify and stress rise, our risk matrix will pick it up and we will cut our risk exposure immediately.

Article

Markets have recently tested and closed below their January lows. Whilst very little has changed since our last update, we are constantly revisiting all our data points to check whether we have missed something. Our Risk Matrix had remained neutral for January and open-source financial risk models are not highlighting high stress levels despite media reports of continued investor angst towards banks, high yield bonds and commodities.

Investor sentiment is currently in the doldrums with so many concerns swirling around. Pessimism at current levels is enough for a short oversold rally to take place. We would be more concerned if the current sell-off still had a large number of bullish investors as it would mean further and larger declines ahead.

Should there be a rally off the bottoms, we would want to check to see whether it is sustainable or should we be expecting further declines to bear market levels. Here are the areas we are also watching out for:

1) We highlighted earlier that our macroeconomic models did not show a global recession. Leading indicators whilst showing slow growth are also not indicating any cracks in the global economy. Whilst there will be weakness in some of the countries, the overall signs do not point to a widespread occurrence just yet. We would also like to see some stabilisation in the commodity sector, and especially for oil to ease investor’s concerns. These signs are likely to manifest in market data such as high yield spreads, energy and financial stocks before showing up in the real economy.

2) We have seen that investor pessimism has already reached extremes. The US presidential election is another area of uncertainty that investors do not like is currently affecting the largest economy in the world. Once we see the completion of more primaries and a clearer signal of the US presidential candidates, then investors can reasonably extrapolate future policies of the US government. As such we do not expect further excessive declines but more of a volatile range-bound environment.

3) We would want to see a clear path to sustainable earnings for companies. Thus far, the majority of the companies that have reported earnings this season have managed to beat estimates. However, expectations had been set very low. However, if future guidance is positive, then the markets would be much more assured. From the recent corporate earnings calls, there does not seem to be excessive negative revision put forth which leads us to believe that earnings would remain quite stable this year.

4) We want to see positive price action in the markets once we get a rally off the bottom. We are watching market breadth, short term advance/declines and a resumption of risk taking to assure us that a sustainable rally is in place.

Without a recession, any correction or bear market is a cyclical one. Markets correct all the time and investors should not be surprised when this happens. We call this type of occurrence an “Echo Bear”. The median drawdown is lower and recovery rate is much higher than a full blown recessionary bear market. However in order to quantify the magnitude of such a drawdown, we would like to highlight that stock markets could see a drawdown of -19% with the cycle lasting slightly over half a year. Based on the current cycle which started in Aug 2015, we could soon see this process fully played out.

Final thoughts

To summarise, we ask investors not to panic, despite the negative news headlines we see each day. The real economy does not yet signal a recessionary environment. We are watching the above 4 factors as well as our risk matrix closely and will move to safer assets should the signals change. We urge all clients to approve our rebalancing recommendation sent earlier and to remain calm.

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