Thursday, November 29th, 2018

Don’t Forget the Skew

Like many other commentators, we are less confident about the direction of equity markets than we have been for several years. Our models are very clear that investors are not being adequately rewarded for the risks they are taking and that they should reduce their exposure wherever possible. Whenever we reached this conclusion on previous occasions in this long bull market, we could at least agree with clients that central banks would eventually step in and prevent the market from falling too far. In other words, equities would endure a period when they were not risk-efficient but it would all be all right in the end.

Now we are not so sure. There will always be some sort of central bank put option, but the Fed and the ECB and others are trying to persuade investors that they are less likely to use it because the financial system is more robust. The only way of testing this hypothesis is for everybody to observe what happens when markets fall.

Even though our models suggest that the direction of equity markets is down, there any number of short-term problems which could be solved and which cause the index to bounce e.g. US China trade talks, Brexit passing the UK Parliament, the Fed stepping away from four rate rises in 2019. We have two choices. We either plan for a continuous bear market or one where there may be violent changes in short-term direction, but a medium-term tendency to decline.

Assuming that clients want to retain some exposure to a diversified portfolio of global equities, we need to decide which countries to own and which to sell. In the first case, we should sell those with the highest beta to falling markets. In the second we sell those with the worst skew i.e. the worst combination of low beta when equities are rising and high beta when they are falling.

In order to measure this, we have gone back to 1995, which is the effectively the start of the late 1990’s bull market and divided the period since then into seven regimes: four bull and three bear – all based on the performance of US equities on a total return basis. The 2000-03 and 2007-09 bear markets are easy to identify, but we have also classified the period from May 2015 to February 2016 as a bear market on the grounds that performance was so far below the trend of neighbouring periods. All our measurements of are based on weekly total returns in dollars compared with US – not global – equities. However, we believe that our results would not be materially different if we had used global equities as the base.

If you believe in the continuous bear market thesis, the countries you should sell (highest bear beta) are: Brazil, Mexico, Finland, Russia, Sweden, South Africa, Germany, Canada, Turkey and Korea.

The countries you should own on the same basis (lowest bear beta) are: Peru, India, Thailand, Czech Republic, New Zealand, Japan, Philippines, Malaysia, Israel and Pakistan.

If you believe in the violent change of direction thesis, the countries you should sell (worst bull bear skew) are: Australia, South Africa, Turkey, Colombia, UK, Denmark, Canada, Russia, China and Mexico.

The countries you should own on the same basis (best bull bear skew) are: Israel, Hungary, Poland, Philippines, Singapore, Austria, Spain, Brazil, Ireland and Thailand.

We think there are two important messages that come out of this exercise. First, these results completely cut across conventional classifications such as emerging or developed markets. For instance, Germany, Sweden and Canada are more risky in falling markets than Israel, India or Malaysia. Second, several so-called safe markets like the UK, Australia and Denmark suffer from a significant negative skew. Investors pay for their downside protection by sacrificing a disproportionate amount of upside. Of course, whatever happens over the next few months may not be in line with past performance, but investors should at least know what historical record is before they decide to do something different.

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