As the Covid-19 crash unfolds, equity investors who properly position their portfolios for the subsequent recovery can significantly outperform the broader market.
To gain insights into what the future may hold we examined three historical crashes and their recoveries.
While crashes are all idiosyncratic, recoveries all look rather similarThe 1987 crash lasted only three months, and the global financial crisis lasted 16 months.
Both were similar because their recoveries were mirror-images of their crashes: factors that did poorly in the downturn posted the best performance in the recovery.
The tech bubble focused on one industry and heavily hit the US and some other developed markets and had a jumble of factor performances with no discernable pattern.
Research approach
We examine how different equity sub-factors behaved in past crashes and in subsequent recoveries – the 1987 crash, the tech bubble and the global financial crisis – to shed light on how investors should position their portfolios in the near term.
To do so we measured the returns posted by factor-specific portfolios made of stocks with the highest scores of each of Style Analytics’ standard 23 sub-factors, which are grouped into seven investment styles: value, yield, growth, quality, size, momentum and volatility.
Crashes
The 1987 crash was the shortest of the crashes (only 3 months) losing 30 per cent in the US markets.
The global financial crisis was the most widespread crash, impacting all markets over a 16-month period with a 50 per cent drop.
The tech bubble was the most concentrated of the crashes, centred on overvalued technology and growth stocks in developed markets and especially in the US.
Key points
- Equity investors can reposition their portfolios for a recovery from Covid-19
- It is helpful to analyse previous crashes and recoveries
- It is possible that the recovery will come in two phases
Each crash had its own particular sub-factor signature, but there are common trends:
• Low-volatility stocks consistently did well across the crashes/regions. High-volatility stocks did poorly.
• Quality stocks work well, with the exception of the 1987 crash in emerging markets.
• Avoiding small-cap stocks, which is conventional wisdom during a downturn, worked well in the US in 1987 and in the global financial crisis but not elsewhere.
• Generally avoiding both growth and value was the right move.
• The current Covid-19 crash has most closely resembled the global financial crisis from a factor perspective.
Unlike crashes, which have different factor characteristics, recoveries tend to resemble each other in all regions:
• Value and dividend yield are strong winners followed by small cap.
• High volatility is almost as good as value.
• Momentum is lacklustre, tending towards negative.
• Growth and low volatility are clear losers.
While crashes are all idiosyncratic with different factor signatures, recoveries all look rather similar, strongly favouring value, small cap and high-volatility stocks.
The chart shows the sub-factors sorted from highest outperforming to worst underperforming together with the average monthly return over the crash (peak to trough) and subsequent recovery (trough back to original peak).
The global financial crisis and the 1987 crashes, in the US, show a strong reversal tendency: those factors that do worst in the crash do best in the subsequent recovery. As recoveries take two to three times longer than crashes, the average monthly returns during recoveries are lower.
What does this mean for the Covid-19 crash?
The current Covid-19 downturn most resembles the global financial crisis. That crash and the 1987 crash, together with their respective recoveries, are useful guides to today’s markets.
But factor performances since the March 23 ‘bottom’ do not resemble their behaviour in any historical recovery we examined.
If the downturn resumes:
• Portfolios that avoid high-volatility and small-cap stocks will likely outperform.
• Investors who shy away from both value and growth strategies should do well.
• Quality, low-volatility and large-cap stocks work best for defensive posturing.
During a full-fledged recovery:
• High-volatility/small-cap and especially value strategies should outperform.
• Growth and low volatility both lag the market.
• Momentum is a mixed bag.
Another possibility is that this recovery will be unlike any previous recovery.
Whether the market has bottomed out or not, once it does start its recovery, history would tell us that value stocks should do very well.
But this crash has not been like any other crash we have seen. Who would have predicted, just two months ago, that volatile growth stocks would be defensive?
Damian Handzy is chief commercial officer and James Monroe is client consultant at Style Analytics
