No-one is sure what the short-term future looks like for markets given the unprecedented nature of the coronavirus pandemic but strategists at Columbia Threadneedle believe history can hint at some of the patterns that might be seen in the eventual recovery.
“In the midst of confidence shattering drops in the markets, it’s easy to lose sight of the fact that these types of events have occurred before, and that they can even lay the groundwork for opportunity,” they explained.
Every stock market crash and following recovery have their own unique aspects. However, after looking at the most recent structural bear markets (1987, 2001-2002 and 2008-2009), Columbia Threadneedle thinks there are patterns that could recur as the market start to recover from the coronavirus crisis.
Below, we look at five of these patterns that Columbia Threadneedle’s strategists think could be seen in the next recovery.
Defensive stocks tend to lag while cyclical stocks tend to lead
The performance of the various sectors in previous recoveries suggests that stocks with cyclical sensitivity, such financials, materials and industrials, tend to outperform in the early stages while defensive areas like consumer staples, healthcare and utilities usually lag.
This pattern “largely holds true” in the six-month and one-year returns that followed the last three recent bear markets. However, Columbia Threadneedle’s strategists added that this might not be exactly the case with the coronavirus recovery.
Average relative sector performance 1 year after 1987, 2002 and 2009 market troughs
Source: Columbia Threadneedle Investments
“It is important to note that in the current environment, we may see a variation on these trends. Certain healthcare stocks, which historically lagged, may be much stronger performers given the demand for testing, diagnostics, tools and products,” they said.
“There has also been an explosion in online consumption, whether it’s for groceries, education or broader retail. What started out of necessity for many may perhaps become the norm – and it will be important for investors to recognise these changes.”
Cyclical and value quantitative factors may perform better than momentum and growth factors
‘Factors’ are patterns of return that investors can isolate and base their investment decisions on. A classic example is that small-cap stocks tend to outperform large caps over time, but factors can also focus on volatility, valuations, dividends and a number of other characteristics.
Average factor performance 1 year after 1987, 2002 and 2009 market troughs
Source: Columbia Threadneedle Investments
“During periods of recovery from bear markets, quantitative factors that focus on cyclical and value characteristics tend to outperform,” Columbia Threadneedle said.
“Factors that target characteristics such as rising price momentum, profitability potential and growth rates tend to underperform.”
In the early days of a recovery, investors may avoid the sectors and industries that led the decline
After the dotcom bubble burst at the start of the millennium, investors shied away from tech stocks as they remembered the pain it caused their portfolios and were wary of getting their fingers burnt again.
“Recency bias, the tendency for people to emphasise current reality over past experiences and future planning, can skew decisions about the risks of investing in certain companies or sectors,” the strategists said.
“In the current environment, it’s easy to understand why investors might avoid travel and hospitality stocks, which led the way down, because it may take longer for them to fully recover.”
The sectors that led the decline can turn around dramatically during recovery
Source: Columbia Threadneedle Investments
However, Columbia Threadneedle said that avoiding sectors can be “a strategic mistake” for long-term investors from both a diversification perspective and because of the missed opportunity to buy assets at attractive valuations.
The table above shows how the sectors that led the declines in the past three bear markets went on to outperform in the 12 months of recovery that followed.
Winners and losers sometimes defy easy classification
Columbia Threadneedle’s analysts added that investing successfully in a recovery is about more than just targeting the right balance of sector exposures.
Looking at the returns of a sector as a whole can mask the “true nature of that sector’s performance”, as aggregate returns can be dominated by the outsized results of one stock or small group of companies.
The chart below shows the percentage of stocks in each sector that outperformed the S&P 500 in recoveries. The ‘hit rates’ of areas like financials, consumer discretionary and technology are high, but it’s important to note that even the laggards on a sector level still have plenty of companies that beat the wider index.
Average 12-month sector performance relative to the s&p 500 following the 1987, 2002, and 2009 market troughs
Source: Columbia Threadneedle Investments
“When sectors outperform, it is rare that every stock in those sectors beats the market. Conversely, for sectors that underperform, not all stocks in the category lag,” Columbia Threadneedle said.
“This is one of the main reasons we believe active portfolio management can make a difference during market recoveries. It’s not sufficient to simply identify winning sectors and it may be, to a certain extent, irrelevant.
“The best performing sectors do tend to have the highest number of stocks that exceed the performance of the S&P 500 over the same time period, but even the lowest-performing sectors have a fair representation of companies that outperform the index.”
Volatility is likely to continue
The CBOE Volatility index – or VIX – is a measure of stock market volatility and is often known as ‘Wall Street’s fear gauge’. At times of market stress, the Vix tends to shoot up.
Columbia Threadneedle highlighted the performance of the Vix during the 2008-2009 global financial crisis and pointed out that it spiked during the peal of the crisis in 2008.
While it then trended downwards, there were a series of ‘aftershocks’ – which can be seen in the chart below.
Volatility during the 2008-2009 global financial crisis
Source: Columbia Threadneedle Investments
“If we follow a similar pattern in the current environment, we could continue to see episodes of volatility — sometimes dramatic — for an extended period,” the strategists finished.
“Subsequent to their peak, these episodes will likely decrease in frequency and magnitude, but they can still be unnerving and costly in the short term.”