Crisis investing

The world is not fundamentally understandable and reasonable, it can't always be mastered through analysis and planning. However investing in times of crisis is not as hard as it seems.

Hey riders,

We are 3 months in one of the biggest crisis in history, which is also the fastest collapse, and recovery, we have ever seen.

"The time to buy is when there is blood in the streets" - Baron Rothschild

"The spoils of war come only in wartime" - Oliver Joost

The 2008 financial crisis and the great recession that followed are still fresh in the memories of investors: many of them lost their rationality, overreacted and made matters worse. As new investors we want to learn from their mistakes, because methodical investors see the stock market collapses as opportunities.

Next week we will make our very first investment. But before that we need to study and understand what did and did not work in prior crisis.

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Summary:

  • Predictability in times of crisis

  • High-Yield spread

  • What works by asset class

Predictability in times of crisis

In crisis periods investors and lenders panic and start behaving irrationally. They stop new lending and investing, pull money out of the markets, and firms that rely on external financing reduce spending. Weaker firms go bankrupt in the process. (Ben Bernanke wrote about it in The Financial Accelerator and Flight to Quality)

"It is difficult to predict — especially the future" - Niels Bohr

Smart people tend to be seduced into thinking they can overcome uncertainty of the future. It is one of the most tragic poems of human history. A poem that Nassim Taleb named the Soviet-Harvard illusion

"Thinking that the reasons for things are, by default, accessible to you. Also called Naive Rationalism" - Nassim Taleb

The world is not fundamentally understandable and reasonable, it can't always be mastered through analysis and planning. However investing in times of crisis is not as hard as it seems.

Investors who can (and can afford to) keep their heads when everyone is losing theirs can exploit simple predictable rules to make significantly outsized returns.

"Happy families are all alike, every unhappy family is unhappy in its own way" - Tolstoy

Markets are the opposite. Bull markets are all bullish in their own ways. In Time-varying short-horizon predictability researchers from the University of Melbourne find that the short-horizon informativeness of aggregate return predictors such as the dividend and short rate diminish greatly during business cycle expansion (bull market). In other words returns in equity markets are 8x as predictive during recessions as during expansions.

Simple and logical quantitative factors are significantly more predictive during times of economic crisis than during expansions. Crises are high-stress environments where basic tests of solvency and profitability become important in dictating a company’s survival and economic future. Companies like Tesla and WeWork may thrive during expansions when money is cheap, but such excesses do not long survive in times of market turmoil.

The first step is to identify such times. For that we use an indicator called the High-Yield spread.

High-yield spread

The high-yield spread measures the spread between the borrowing rate for below investment-grade bonds and the corresponding safe interest rate. It is a gauge for monitoring market sentiment for small and micro-cap companies. When the high-yield spread rises, it reflects higher borrowing costs for smaller, less-creditworthy business.

During recessions, the high-yield spread spikes upward and default rates soar. This stress rewards companies that are profitable and cash generative, while weak firms and companies that are investing heavily and burning cash struggle and often go bankrupt.

Therefore the high-yield spread is a good indicator of financial distress. An estimation is available here

What works by asset class

In the past weeks we discussed about asset classes and multi-asset class portfolio allocation but which asset classes are performing better in times of crisis?

Let’s arbitrarily define a “crisis” as a time when the high-yield spread are above 6.5%, and let’s look at the respective performances of asset classes inside and outside these periods (i.e. how they perform when high-yield spreads are above and below 6.5%).

Two asset classes outperform the US Market Index in times of crisis:

  • Small value stocks

  • High-yield bonds

What works in stocks

Given the significant outperformance of small value during these time periods, a dedicated public small value exposure is the optimal way to capitalize on these moments. On way to invest in small value stocks is through ETFs (such as iShares Core S&P Small-Cap ETF or iShares Russell 2000 ETF ) another, and more advanced, is to stock pick companies.

If you want to do the later you should look at the following indicators: asset turnover, positive net income, volume and leverage. I will write an dedicated article on this mater in the future.

What works in bonds

High-yield crises are one of the few times in the market when it makes sense to reach for yield in credit: lower-rated B and CCC credits outperform. (Such as iShares iBoxx $ High Yield Corporate Bond ETF or SPDR Bloomberg Barclays High Yield Bond ETF).


That’s all for today! And it was the last theoretical article of the series: next week we will make our first investment!

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Also, if you have any question or feedback: leave a comment :)

See you next week!

Kevin from Hook


Further readings:


This newsletter does not provide investment advice
As always, trading activity is risky and exposes you to loss of capital. Never invest more than you can afford to lose. Never. The information presented on this page (and every other) are not investments counsels. Your use of this content is at your own risk. The content is provided “as is” and without warranty of any kind, either expressed or implied. All views and opinions expressed here are the author’s own, and are not representative of the views of any current, past or future employer.