The Meta Strategy in a Crash

Last month´s crash was (and still is) very special. Caused by the double shock of an escalating coronavirus crisis, that continues to hold the world in its grip, and an oil price shock, stocks fell nonstop from lofty valuations and an environment of growing complacency and bullishness. A week of the fastest drop into correction territory in US history continued, after barely a breather, with an unprecedented record crash into bear market territory under extreme volatility (a rollercoaster of limit down & up days in S&P futures markets, violent reversals and several daily swings of more than 10%). And this was followed by yet another week of carnage without any sort of sustainable bounce for more than a single day.
As yet there is no end in sight.

So let’s have a close look at how a systematic investment strategy deals with such an uncommon situation. Can it still add value?

By design the Meta Strategy aims to be invested primarily in equities whenever the market indicates an environment that is likely to provide high returns. To deal with the large drawdowns an equity centered portfolio suffers through every once in a while it combines fundamental and technical indicators to signal an exit when conditions deteriorate, but the drawdown is still relatively moderate. It is essentially a long-term trend-following strategy which uses economic fundamentals to calibrate the sensitivity of its exit signals. 

This works quite well in a „classic“ bear market, where the economy shows slowly increasing levels of stress which can be seen in a variety of leading economic indicators; e.g. the unemployment rate, the US treasury yield curve and others. Around the same time (sometimes a bit earlier, sometimes after we already see fundamentals deteriorate) equity prices themselves begin to fall and volatility rises. The Meta Strategy uses these inputs to time an exit from the stock market into safer assets. (read all about the details starting here)

This process, when we turn from a bull market to a bear market environment, usually takes time (several months, even if it is initially triggered by exogenous events, e.g. a natural disaster) and let’s us evaluate on a monthly basis how much risk to take in our portfolio.

As painful as last month´s crash was, it is also interesting as it is a unique occurrence (at least in the history of the US stock market) and we can have a close look at how the Meta Strategy holds up in such a „worst case” environment of a sudden crash that happened pretty much out of the blue and was unprecedented in its speed.

The Meta Strategy signals during the crash
By now the Meta Strategy has rotated completely into cash which happened in two stages:

  • Signal 1: on 2/27/20 a reduction in equity risk by half was signaled by two technical indicators (the long-term moving average was broken and the VIX Futures Term Structure inverted significantly). By this time the S&P 500 had given back 13,2% of its gains since reaching its all-time high barely one week earlier. A decent bounce a few days later gave several good possibilities to exit which I indicated in the March 3rd edition of the Meta Strategy newsletter. As hard as it is to imagine this now, the probability of seeing a false signal was still very high at this point – a healthy correction down to the long-term trend was not unexpected.
  • Signal 2: only a week later this changed when the S&P 500 dropped below the prior low and the strategy’s stop loss signal was triggered (the long-term moving average was broken for a second time and the VIX Futures Term Structure inverted beyond its stop loss threshold). We now saw ourselves 18,6% below the high.
  • All-in-all the defensive strategy, being 100% invested in equities at the outset, suffered a drawdown of 16%. This is very close to the historical average drawdown we can expect to see from the strategy at the point an exit signal is triggered. That this „worst case“ hasn’t actually resulted in a worst case drawdown is due to the incredible volatility of the move which triggered the strongest volatility-based stop loss signal quite early.

The strategy now sits in cash (due to the high volatility across all asset classes) and waits for the next entry signal.

Leverage
The Meta Strategy Aggressive ETF Portfolio uses 2x leveraged equity ETF to boost returns. Leverage is a double edged sword as it increases drawdowns just as much as upside gains. Signal 1 caused the strategy to rotate out of leveraged ETF into unleveraged stock exposure, but at this point SSO (a 2x leveraged S&P 500 ETF) was down 23,4%. Overall the drawdown at the stop loss exit point was 28,8%, but this was compensated by larger gains in the run-up to all-time highs. 
Year-over-year SSO was still up by 11% when Signal 1 was triggered (SPY up 6,5% from 2/27/19 to 2/27/20). In this case the slight outperformance was not really worth the experience of such a gut-wrenching drawdown, but backtests show, that over the long run the leveraged strategy version posts significantly higher returns – at the price of experiencing high volatility.

Did the strategy work as planned?
From the Meta Strategy mission statement: 
“The defensive portfolio aims to earn the same return as the stock market, but with only half the maximum losses from the peaks over the long term.
The aggressive portfolio, for investors who can stomach the risk of drawdowns as high as we have seen in the stock market in the past as well as higher short-term fluctuations, aims for returns that beat the stock market over the long term.“

As we have already seen a drawdown beyond 30% in the S&P 500 by now, the strategy worked according to plan as long as the investor actually implemented the signals in time.

Investor psychology
And this is probably the most important point: a strategy is only as good as the investor following it
It is very hard to exit during a drawdown – the urge to „wait for a bounce“ is extraordinarily strong as we anchor to the portfolio highs we saw just a week prior. This actually would have worked quite well to curb up to half of the drawdown following Signal 1. 
After Signal 2, however, prices just continued to drop while historic comparisons to similar extreme crash situations (e.g. 1987, 2008 or 2011) pointed to a very high probability of higher prices over the course of the next 2 – 3 months. This may still happen, but the path is already gut-wrenching – and chances continue to rise, that it just won’t.

I wish you all the best & stay safe!

David

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