May 2020 / INVESTMENT INSIGHTS
Perfect Imperfection: Contrarian Investing During a Sell-Off
Rewards to be found without timing the market trough
- Investors are often obsessed with timing the market perfectly—of finding the exact moment a bull market peaks or a bear market hits a bottom.
- Our analysis of 17 major drawdowns over 90 years suggests that investors who add risk during a sell‑off can mistime the bottom and still make major gains.
- Our analysis shows increasing allocation to stocks one month either side of a trough can deliver significant returns a year later.
Knowing the precise moment that a bull market peaks or a bear market hits a bottom would offer guaranteed success—and a very early retirement. But our analysis of severe downturns over the past 90 years suggests that it is not necessary to time the bottom precisely. Investors who add risk during a major sell‑off can mistime the bottom by some distance and still make considerable gains—in other words, we believe it pays to be contrarian during a crisis irrespective of whether you manage to time the absolute market bottom perfectly.
A Lesson From History
There are many ways in which the coronavirus pandemic market crisis has been historic: the nature of the shock (a pandemic); the speed of the equity sell‑off; the rapidity with which liquidity vanished from credit markets; the abrupt stop of the real economy; and the size of the stimulus measures. As the crisis continues to play out, investors across the world are grappling with the challenge of how—and when—to allocate their assets. While it is important that investors remain diversified and invested for the long run, short‑term tactical asset allocation decisions can add value by over- or underweighting risk assets to take advantage of shorter‑term relative value opportunities. These tactical decisions should be made in the context of long‑term strategic weights—not to shift assets from 0%–100% in favor of stocks or bonds.
In the current environment, while the benefits of adding risk assets when they are cheap are obvious enough, choosing the right moment to do so is a daunting proposition. At the heart of this dilemma is a simple question: What is the price of being too early or too late?
To seek an answer to that question, we examined 17 episodes in which the S&P 500 Index sold off by 15% or more, beginning with the Crash of 1929. These episodes are circled in blue in Figure 1. The final circle marks the current downturn, which was not included in our analysis.
There Have Been 18 Major Sell‑Offs Since 1928
(Fig. 1) March 2020’s low was the joint eighth worst
We calculated the average returns for a hypothetical investor trying to time the bottom of each of these 17 drawdowns, working on the assumption that the investor tactically shifts from a 60% stocks/40% bonds allocation to a 70% stocks/30% bonds mix when they think they are at the bottom of the market. Our analysis revealed that if the investor had timed the bottom of the market perfectly, average alpha would have been quite high: One year after shifting 10% of the portfolio from bonds to stocks, the hypothetical investor would have earned an average of around 500 bps of alpha.
What is particularly surprising is the fact that the investor could have added to stocks anywhere between three months before and three months after the absolute bottom of the market and still added value a year later; even adding to stocks six months either side of the bottom would eventually reap rewards. Or to put it another way, it is possible to mistime the bottom a lot and still make money by adding stocks during a market crisis.
Figure 2 shows the results in more detail. It reveals that if we had added 10% to stocks one month before the trough, average returns 12 months forward would be 274 bps higher than the 60/40 benchmark. If we had added to stocks one month after the trough, results would have been similar—in fact, they would have been slightly better, implying that it’s better to be late than early. However, the most important finding is that adding to stocks would have boosted returns in most of the 17 major drawdowns since 1928—in other words, based on 90 years’ worth of data, we know that adding to stocks after a major sell‑off has turned out to be the right decision.
To confirm these results, we re‑ran the analysis, this time measuring the percentage return from the bottom instead of the time from the bottom. The outcomes were similar: Mistiming the bottom by 10%–15% either side would still have added value in the combined 17 drawdowns, with an average alpha of more than 200 bps a year later.
Adding Equities During a Sell-Off Has Boosted Returns
(Fig. 2) The impact of adding 10% stocks to a 60% stock/40% bond portfolio
In addition, we measured the impact that daily rebalancing had on the portfolio by comparing returns if rebalancing had occurred monthly or not at all. We found that rebalancing would have had very little impact on returns.
Being Contrarian Can Be a Smart Strategy
The “current” low of the coronavirus crisis occurred on March 23, when the S&P 500 Index closed 33% lower than its all‑time high, which it reached on February 19. Stocks then rebounded more than 25% from that low over the next 18 days. This was a much faster recovery than in the 17 drawdowns in our study, where the average time to rebound 20% was 65 days.
At present, there is no clear sign of whether the current sell‑off reached a bottom on March 23 or will retest that low in the coming months. As our analysis shows, however, increasing allocations to stocks during a severe market sell‑off has historically, invariably paid off in the long term irrespective of the precision of timing. As counterintuitive as it may sometimes feel, history shows that adding risk, even when it might not be clear whether markets have reached a bottom, can be a rewarding investment strategy.
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