Let’s start with the obvious. Markets in 2022 are volatile. There have been some short-term, fast fluctuations, full of emotion. The last few weeks alone have seen widespread selling, fueled by investor pessimism.
We all know that investing is a lifelong endeavor. The market is dynamic and will do whatever it takes to confuse the masses. The success of any long-term investment program depends on making many good short-term decisions. Decisions that allow the portfolio to adapt to changing market conditions. This is especially true when markets become volatile, with bears raising their heads when they least expect it. It’s important to always remember that making money in good times means nothing if you can’t keep it in hard times.
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We have entered a true bear market for the first time since the 2008 financial crisis. A bear market does not necessarily mean that we have no choice but to endure significant economic damage. Times have changed and we now have more options than ever before to manage bear markets in both equities and bonds.
This update begins with an overview of why 2022 will be different than any market environment seen since the end of Q1 2009, over 12 years ago. Following the overview, we will discuss the structure of the bear market. Finally, we briefly discuss adaptive portfolio management and how to benefit from, rather than be penalized by, existing high volatility.
Now that the first nine months of 2022 have passed, most investors need a reminder of what a real bear market might feel like. By the end of September, the S&P 500 was down -24%, the Nasdaq down -32.5% and the 20-year Treasury down -29%. The current market environment should not be confused with the rare “trading anomaly” seen early in the 2020 COVID-19 crisis.
2020 saw an example of what Canterbury called a “giant trading anomaly.” The S&P 500 is down -32% in just 23 trading days.Then the market rose again break even However 5 months later.
The current bear market appears to be dragging on. This bear shows no signs of ending soon.
market of the year
Below are bullet points highlighting the wild swings we’ll see in the 2022 bear market. So far this year’s theme has been about market volatility. This was especially true during his third term.rd quarter.
- The second quarter ended with the S&P 500 recovering from its June lows. From mid-June to mid-August, the market rose +17% in just two months. At the time, the market index was still down 10% from the highs established in the first week of the year.
- A +17% rise was immediately followed by a -17% move in the opposite direction to end the quarter. That’s a lot of volatility!
- The S&P 500 fell -9.3% in September alone, its worst September since 2002. The month had 8 “abnormal days” (trading days greater than +/-1.50%). As an overview, according to accepted mathematical statistics, the S&P 500 is expected to have only a total of 13 outliers over the entire year.
- There are 62 days of “outliers” in 2022, and over 4.5 years of outliers.
- The decline in September was widely felt. Even the most ‘defensive’ sectors such as consumer staples, energy and utilities felt the effects of market volatility.
- A stock bear market isn’t the only problem facing many conservative investors. The bigger question is about the corresponding bond bear market. Long-term government bonds fell in September alone -8%, and a whopping -29% decline in 2022. To make matters worse, the 20-year US Treasury is down 40% from its all-time high in 2020.
- A balanced allocation of 60% equities and 40% bonds yields approximately -22% YoY. In other words, traditional “conservative asset allocation” has never been conservative.
bear market anatomy
As seen this year, bear markets are characterized by having days of high volatility and outliers far beyond what is predicted by statistical analysis. Bear markets are counterintuitive and tend to go up when investors are most pessimistic.
Financial markets are known as leading indicators of changing fundamental data. In other words, it’s common for markets or securities to rise before good reports. This is because some investors notice new information and react quickly. Other investors may be ill-informed or generally slow to notice changes and react slowly. There is a saying on Wall Street, “buy the rumor, sell the news.”
On the other hand, the same is true when investors react to bad news, especially during bear markets. The difference is that during bear markets, investors are more likely to be more cautious and overreact to daily news events. Their emotional behavior contributes to increased volatility. Come to think of it, behavioral finance and human psychology will inevitably affect liquid financial markets.
We can see this in real time in 2022. The market has seen several emotional swings. Both are up and down. Investors are feeling different emotions during each of these swings, which is consistent with the short-term movement of the market.
The chart below shows investor sentiment at the peak and trough of each market in 2022. Investors felt more bearish at the pre-bounce trough and less bearish as the S&P 500 rose to a relative peak.
Source: Association of Individual Investors sentiment survey data. Charts created using Optuma technical analysis software
Visually, a bear market establishes a chart pattern with lower lows and lower highs. You can see this above. A bear market also has large short-term fluctuations in a short period of time. A bear market is therefore more volatile and more likely to see a sharp parabolic drop followed by an equally sharp short-term rally. This has been seen many times in 2022.
at the end of 3rd Pessimism was at its highest level since 2009 in the fourth quarter. The magnitude and timing of future gains is an unknown variable, but heightened pessimism puts the market in a position to do the opposite of what most people would expect.
There are three main certainties about a bear market.
- A bear market is volatile.
- Market moves in both directions tend to be greater than those seen in bull markets and occur rapidly. The biggest up days and uptrends tend to occur during bear markets. In other words, if you want to catch an uptick, you need to add money to your capital following a sharp downturn when pessimism is at its peak.This is the case for bear markets Rallies happen very quickly, so if you haven’t already, it’s difficult to join immediately before the rally ends.
- Every bear market is eventually followed by a new bull market. The goal of successful adaptive portfolio management is to manage bear markets by adjusting holdings in a way that maintains high diversification returns. Own securities with low correlation. Low correlation means low volatility. A low volatility portfolio benefits from market volatility rather than being penalized by it. Remember that volatility is the long-term compounding killer of returns.
Adaptive portfolio management
Canterbury’s primary objective is to manage its portfolio in a way that will benefit from the kind of bear market expansion that we are currently experiencing in both equity and fixed income markets. We use a process called “adaptive portfolio management”.
An adaptive portfolio should adjust its diversification in what we call an “efficient portfolio”, or in a way that maintains consistently low volatility throughout fluctuating market conditions. One way to measure consistently low volatility is to use the concept of “outlier days” that we have often discussed and mentioned earlier in this article. As explained, an “outlier day” is a trading day above +/-1.50%. As mentioned above, an anomaly day should statistically occur once every 20 trading days, or 13 times a year.
So far in 2022, the market has experienced 62 days of outliers (six times the expected volume so far in the year). While the fixed income metrics are slightly different, the 20-year treasury is above +/-1.50% for 46 days, and one of the balanced Vanguard 60% equity/40% bond mutual funds has posted 21 so far this year. We are experiencing outliers for the day.
So far this year, Canterbury’s adaptive portfolio strategy, the Canterbury Portfolio Thermostat, has experienced only eight unusual days that it would experience in a normal market environment with limited volatility.
Even with limited volatility, limiting outliers is not enough to profit from a bear market. Adaptive portfolios need to hold down falls, but also participate in the sharp bear market rally that is common in today’s market environment and expected. Nothing too good (limiting the fall) benefits from a bear market unless the portfolio can participate in the bear market rally. For this reason, adaptive portfolios increase exposure to equities during downturns to best participate in the upswing that immediately follows.
The Canterbury Portfolio Thermostat is now significantly less volatile than the market as a whole, and even half the most conservative balanced portfolios have half the volatility. Currently, energy, utilities, US dollars, and reverse Financial and emerging market positions (moving in the opposite direction of the underlying index).
September was a difficult month for many investors, regardless of how they invested. All sectors saw general declines, including technology, financials and defensive sectors such as utilities and energy. Virtually all asset classes other than the US dollar and inverse securities are in volatile bear market conditions.
This bear market has led investors to expect the unexpected. 2021 trading days rarely exceeded +/-1.50%. In fact, the S&P 500 experienced only 18 of them. There are currently 62 anomalous days, and there are still a quarter left in the year. Days above +/-1.50% feel like the new normal. The sell-off experienced last month leading up to the end of the third quarter has prompted many market participants to throw in the towel and stay away from the market. This is especially true for conservative investors, where bonds do little to offset stock market downside risk.
Profiting from a bear market requires an evidence-based adaptation process. Bear markets are full of surprises. If you think things are bad, you will also decline. Markets rebound when they find themselves at their most pessimistic. No one can predict the market. The market already knows what we know and knows it before we know it. By having a process like the Canterbury Portfolio Thermostat, investors can take advantage of the biggest disadvantage of a volatile bear market, limit portfolio declines, and use the process outlined in this article to avoid market volatility. You can turn a bear market in your favor by making a profit from. update.
We hope you find this update helpful. If you have any questions or comments, please feel free to call our office.
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