Multi-Asset Solutions: Contrarian Investing During a Sell-Off

In the wake of such significant market drawdowns this year, many investors might be wondering if the time is right to lean back into stocks and other risk assets.

However, investors have historically found it challenging to predict troughs in drawdowns like this. This raises the question: What are the potential penalties for being too early or too late in making a tactical shift?

We previously examined this issue after the COVID-19 pandemic generated a major sell-off in U.S. and global equities in the first quarter of 2020.¹ In that study, we looked at equity and fixed income market returns following 17 prior U.S. market declines in which the S&P 500 Index sold off by 15% or more, beginning with the 1929 crash and ending with the December 2018 market correction. More recently, we updated our analysis to include the COVID-19 selloff.²

An important finding in our broader analysis was that historically it wasn’t necessary to time drawdowns precisely to generate significant excess returns:

• If our hypothetical investor had shifted to a 70% U.S. stock/30% U.S. bond allocation one month (21 trading days) before the exact market trough, subsequent 12-month excess returns across the 18 drawdowns could have been 252 basis points (bps) higher, on average, than if they had stuck with a 60/40 allocation (Fig. 1.)
• Raising equity exposure one month after the trough produced roughly similar results, although 12-month excess returns for the 70/30 allocation could have been even higher: an average 410 bps relative to the 60/40 portfolio.
• In both cases—one month before and one month after the trough—the 70/30 allocation outperformed the 60/40 portfolio in 100% of the 12-month periods we examined.

Adding U.S. Equity Exposure in Past Sell-Offs Typically Boosted Returns

(Fig. 1) Average cumulative return differentials and [success rates] for a hypothetical 70% U.S. stock/30% U.S. bond allocation versus a hypothetical 60%/40% portfolio*

Past performance is not a reliable indicator of future performance.
As of July 31, 2022.
*The 2020 COVID-19 sell off was the most recent event examined in our analysis. However, 36-month and 60-month returns were not yet available for the starting points shown before and after the trough of that downturn. Similarly, 60-month returns were not yet available for starting points before and after the trough of the December 2018 market sell off.  Accordingly, results for those periods are not included in the averages above.
Sources: Bloomberg Finance L.P., Morningstar (see Additional Disclosures), and U.S. Treasury/Haver Analytics.
The chart above is shown for illustrative purposes only, does not represent an actual investment, and does not reflect fees and costs of a portfolio. Actual investment results may vary. Equity returns based on daily S&P 500 Index total returns from January 3, 1928, through July 31, 2020. Fixed income returns based on an estimate of daily interpolated returns for the Ibbotson Intermediate Government Bond Index from January 3, 1928, through December 29, 1961, and on daily total returns for the 5-year U.S. Treasury note where daily data were available from January 2, 1962, through July 31, 2022. The return differentials shown above are measured between the cumulative total returns for a hypothetical 70% U.S. stock/30% U.S. bond portfolio and a 60%/40% benchmark in the periods shown, averaged across 18 major historical U.S. equity sell offs. A major sell-off was defined as a decline of 15% or more in the S&P 500 Index. The success rate is the percentage of performance periods in which the 70/30 hypothetical portfolio outperformed the 60/40 benchmark. Results shown were derived from daily rebalancing and daily cumulative returns.

x

However, economic fundamentals matter—and high inflation and rising interest rates present a particularly challenging environment for risk assets. So, we revisited this analysis on focused on only the five historical U.S. equity market drawdowns that occurred during periods of high inflation and high and/or rising interest rates. In our view, the results of this more targeted study suggest that a little more patience may be required before increasing exposure to equities and other risk assets in the current market environment.

For example, when we examined the performance of an investor who shifted from a hypothetical 60/40 portfolio to 70/30 allocation three months (63 trading days) before the trough of a high inflation/rising interest rate drawdown we found that:

• They could have reduced excess returns by an average 52 bps over the following 12-month period, versus a 59 bps average return gain across the full sample of 18 drawdowns (Fig. 2.)
• The 70/30 allocation would have outperformed the 60/40 portfolio in only 20% of all following 12-month periods, versus a 56% success rate across the full sample.

Caution May Be Needed When Inflation Is High and Interest Rates Are Rising

(Fig. 2) Average cumulative return differentials and [success rates] across five high‑inflation, rising‑rate U.S. equity sell‑offs

Past performance is not a reliable indicator of future performance.
As of July 31, 2022.
Sources: Bloomberg Finance L.P., Morningstar (see Additional Disclosures), and U.S. Treasury/Haver Analytics.
The chart above is shown for illustrative purposes only, does not represent an actual investment, and does not reflect fees and costs of a portfolio. Actual investment results may vary. See important disclosures at the end. Equity and fixed income returns, return differentials, and success rates are based on the same benchmarks used in Figure 1. The results shown here are averaged across the five major historical U.S. equity sell-offs, which featured declines of 15% or more in the S&P 500 Index during periods of high inflation and rising interest rates as measured by the yield on the 10‑year Treasury note. High inflation was defined as a year‑over‑year reading of more than 4% in the U.S. CPI at the time of the market trough.

x

Generally, the revised results tend to show an asymmetric benefit to being late rather than early. Reasons for the shift in results could include a U.S. Federal Reserve that must remained engaged in a fight against inflation and perhaps a rebalancing effect, as twin stock and bond sell-offs delay reallocation of fixed income profits to risk assets.

Reflecting this view, the T. Rowe Price Asset Allocation Committee (AAC) continued to hold an underweight position in stocks relative to bonds as of September 30, 2022. However, the AAC recently made a modest reduction in its equity underweight and may consider raising equity exposure further if it observes some combination of a less aggressively hawkish U.S. Federal Reserve and an improvement in economic conditions and earnings visibility.