December 2022 / MULTI-ASSET SOLUTIONS
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*
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
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.
Important Information—Hypothetical Portfolio
The information presented herein for the hypothetical portfolio is hypothetical in nature and is shown for illustrative, informational purposes only. It does not reflect the actual returns of any portfolio /strategy but rather a theoretical blend of the indicated benchmarks. The assumption of constant benchmark weights has been made for research purposes and is unlikely to be realized. The hypothetical portfolios do not reflect actual trading or the impact that material economic, market or other factors may have on weighting decisions. Results do not include management fees, advisory fees, trading costs, and other related fees. Actual results experienced by clients may vary significantly from the hypothetical illustrations shown.
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December 2022 / INTERNATIONAL EQUITIES
December 2022 / ECONOMICS