Probability-based investment modelling for professional and institutional investors
Given the likelihood of a second wave of the pandemic at some stage during the rest of this year, we have gone back through 25 years of data in over 40 countries, to see if there are any lessons about what to do in the immediate aftermath of a very bad sell-off. We find that buying the dip is not always a successful strategy and certainly not as successful as selling the bounce. By far the best strategy is avoiding the really bad weeks completely, which is easier said than done. The uplift from doing this is so significant that it dwarfs any other strategy. Even partial success is worth the effort – and the risk of missing out.
Generating an adequate income from euro-denominated bonds is next to impossible, so investors should abandon the attempt. They should embrace currency risk – not try to hedge it away. They should enjoy the fact that US dollar yields are structurally higher than those in the Eurozone. This means owning long-dated Treasuries and dollar-denominated EM sovereign bonds. Finally, they should consider the source currency of their equity dividends and take another look at the Energy sector.
Provided that that causes of the next bear market in US equities originate in the US, investors should have time to adjust their asset allocation before the correction turns into a full-scale bear market. The necessary rise in excess volatility (equities minus bonds) takes several months and cannot happen without someone noticing.
The frequency distribution of realised volatility for US equities is bi-modal, which suggests there are two overlapping risk-regimes, rather than one continuous one. This would make the US different from the rest of the world and increase the potential for a non-linear market response to an incremental policy action by the Fed.