The Holy Grail for investment manager is finding a way to call inflexion points, i.e. consistently reliably knowing where bull or bear markets start and end, which is no small feat. Second in contention could arguably be to find the most effective ‘flight to safety’ assets to turn to in times of turmoil. We can all agree that the first is extremely hard to achieve consistently, so it would be advantageous to at least achieve the second option; which assets are the most practical always to hold, just in case…
The chart [Fig 1] shows the performance, over the past 50 years, of some of the assets that are often considered to offer protection, against periods where the S&P 500 fell 20% or more.
[Fig 1: Asset performance when the S&P 500 dropped more than 20%, over the last 50 years]
During the Savings and Loans crisis/Latin American debt crisis in the early 80s, Gold would have lost you twice as much as equities. In fact, apart from the 1973-1974 crash (collapse of Bretton Woods), Gold didn’t even come close to negating equity losses in other bear markets.
During the global financial crisis of 2008, the bulk of the Gold rally happened after the fact, only reaching new highs two and a half years after Equity markets had already started to recover. The US dollar depreciated in three out of the six events highlighted in Fig 1, and the Japanese yen did not do much better, making Treasury Bonds the only asset that never lost you money, even though returns in many cases were mediocre.
When it comes to the debate over Fundamentals, Technicals or Quants, as to which offers the best predictive capability, thankfully I am not a purist and find it useful to use all of the tools at my disposal to make the most informed decision I possibly can.
Quantitative Analysis is used to filter through data and formulate ideas, as there is simply too much information for most minds to process all at once. Any trade must have a Fundamental underpin, eliminating the risk of coincidental correlations. Once a trade has been identified, Technical Analysis is key in establishing entry and exit points.
Examples:
Having screened over three thousand other indices for that elusive ‘one size fits all’ bear market protection trade, purely using Quants, the results would point towards the Tajikistan somoni (the currency of Tajikistan), as it appreciated 68,000% during the IT Bubble crash. But, this was purely coincidental as it replaced the Tajikistani ruble on 30 October 2000 at a ratio of 1:1000, so not only was there no Fundamental reason suggesting it would offer protection in any other event, it’s not an investable trade.
In the commodity complex, on average, Cacao offered the best protection, but it’s unlikely that this doubled in value during the early 2000s because of excessive speculation in IT stocks.
The best currency is potentially the Swiss franc, which is sound from a Fundamental perspective, but it devalued about 15% compared to the US dollar concurrently with equity market losses in the early 80s.
When it comes to hedge funds, Global Macro and Managed Futures seemingly offered the best protection; which, fundamentally, makes sense. Bear in mind though, apart from the fact that they can also get it wrong, rigorous compliance on the underlying structures is essential, as highlighted in the 2008 financial crisis.
Conclusion
An obvious conclusion has to be that there is simply no single place to hide; every crisis has different driving forces. The best protection at any given time is having a solid understanding of the current potential of events that can derail markets, and for you to be holding the appropriate assets to protect against that particular risk event.
But, in the real world, it is not that easy to always spot those significant risk events. For instance, John Paulson in “the greatest trade ever”, traded Credit Default Swaps during the sub-prime crisis and made a fortune. Subsequently, he has been struggling though, as none of the other “troubled chickens” he has spotted have come home to roost yet; which highlights the other risks, the ones we are not aware of, the ones that tend to emerge out of nowhere and cause havoc in the markets. For instance, I can think of no indicators that could have warned you about Black Monday, which was triggered by mass panic and automated trading strategies spiralling out of control.
The point to this article is that there is no single solution that offers you complete protection against (or predict the timing of) these blindsiding catastrophes/risk events. A diversified set of assets is always the most prudent strategy, tilted towards the opportunity sets identified by proper research and protected by other appropriate assets based on current risks, but not ignoring the fact that no one has all the information.
Where to hide when the markets crash?
