Please vote here if you think there will be positive returns for IWM from the close of April 30th until the close of the end of the month of May.
Please vote here if you think there will be negative returns for IWM from the close of April 30th until the close of the end of the month of May.
The US has already entered a recession. Almost all of the proven macroeconomic and technical (breadth, volatility, etc.) indicators are signaling further downward momentum for equities.
As hedge-fund billionaire and self-taught historian Ray Dalio said Sunday on Meet the Press, time will tell if it will be something more. In other words, he implied there could be a second Great Depression.
With all the economic and political similarities, I'm fearful the US may be repeating the late-1920s and 1930s, complete with government fiscal and monetary blunders. As always, there will be ways to make money in the market during the coming years, but many will suffer from the economic hardship. Sad.
Don't equities usually go up during a recession? I looked at the last century of recessions in the US and counted 16 of them. The S&P 500 (or its equivalent) went up in 11 of them and down in 5.
True!!
| Recession | Start Date | End Date | Start Value | End Value | Change | Up/Down |
|---|---|---|---|---|---|---|
| 1929-1933 | Aug 1929 | Mar 1933 | 29.58 | 6.21 | -79.0% | Down |
| 1937-1938 | May 1937 | Jun 1938 | 12.48 | 8.96 | -28.2% | Down |
| 1945 | Feb 1945 | Oct 1945 | 15.36 | 17.36 | +13.0% | Up |
| 1948-1949 | Nov 1948 | Oct 1949 | 16.67 | 18.40 | +10.4% | Up |
| 1953-1954 | Jul 1953 | May 1954 | 25.19 | 28.04 | +11.3% | Up |
| 1957-1958 | Aug 1957 | Apr 1958 | 43.92 | 48.25 | +9.8% | Up |
| 1960-1961 | Apr 1960 | Feb 1961 | 55.62 | 69.79 | +25.5% | Up |
| 1969-1970 | Dec 1969 | Nov 1970 | 106.78 | 109.82 | +2.8% | Up |
| 1973-1975 | Nov 1973 | Mar 1975 | 121.74 | 90.25 | -25.9% | Down |
| 1980 | Jan 1980 | Jul 1980 | 107.94 | 114.76 | +6.3% | Up |
| 1981-1982 | Jul 1981 | Nov 1982 | 122.48 | 145.86 | +19.1% | Up |
| 1990-1991 | Jul 1990 | Mar 1991 | 335.78 | 397.63 | +18.4% | Up |
| 2001 | Mar 2001 | Nov 2001 | 1265.80 | 1076.90 | -14.9% | Down |
| 2007-2009 | Dec 2007 | Jun 2009 | 1468.36 | 877.50 | -40.2% | Down |
| 2020 | Feb 2020 | Apr 2020 | 3398.77 | 3100.61 | -8.7% | Down |
Thanks, Whychliffes — clearly you’ve done your research, and I appreciate the historical context.
That said, there’s an important nuance that often gets overlooked in recession/performance discussions: the NBER declares recessions with hindsight. Their calls typically come well after the fact, and one of the indicators they consider is the stock market itself.
So we end up in a bit of a circular situation:
→ A recession period is partially defined by a market decline, with the end marked in part by a market recovery
→ Then we analyze how the market performed during that same period — which the NBER has already factored in
→ It becomes hard for the NBER to continue calling it a deep recession when the stock market has already staged a booming recovery (which they know has occurred — with full 20/20 hindsight)
That makes the whole exercise somewhat arbitrary — especially when it comes to the end of a recession, which is always defined retroactively. By the time the NBER declares it over, the market may have already rallied significantly — in part because of how they define a recession.
Not only are they responding to a recovery in the market, but they also have the benefit of hindsight — they know with complete certainty that there wasn’t a second leg down which we can never be 100% sure about at the time.
This makes it difficult to rely on NBER-dated recessions for forward-looking investment decisions. Historically, the market bottom tends to occur around the midpoint of the NBER-defined recession — which, ironically, only becomes visible long after the fact.
So my question is different:
Rather than focusing on the arbitrary start and end dates of a “recession” declared by the NBER, I’d want to know whether there’s a significant drawdown within the NBER-declared window — and how one might time that decline (if choosing to time it at all).
BTW, I can’t vote on my own post above, but near the end of the month here, I’m going to cast my vote: May will be a down month — but the recovery will begin shortly thereafter. I will not be changing my holding weights based on my predictions (I do adjust somewhat based on volatility).
I like to assign probabilities to my predictions. I’d say there’s about a 55% chance I end up being right after the close of May 31. I’m not highly confident in that call (so thumbs up on a down month and not a heart).
Main reason for my view: I don’t think Powell is especially concerned with making the current administration look good. He’ll focus on finishing the job of taming inflation — even if that means risking a mild recession. In other words: he’ll want to see inflation clearly under control before cutting rates. We might see a few modest quarter-point reductions later in the cycle — but only if they don’t compromise the broader goal of sustained price stability.
No Powell put this time around, in my view.
The beginning of a recession is usually not declared by the NBER until many months after it has started. That means it would be impossible to conduct any market timing around a recession call by the NBER. What I was trying to point out is that if you think a recession is coming up or even if you think it's already here, that's really not a good reason to diminish your exposure to US equities. It might actually be a good reason to increase it.
I agree. The same point I made in my post I believe! True of the beginning and end of the recession. Retrospective NBER recession calls alone are arbitrary and meaningless for predicting the market. Something else needs to be considered or added for timing the decline and the rebound that is often seen in retrospect. Like you, I am unaware of any opinions coming from the NBER about a recession at this time. But if Chawasri is right that we are in one now it will not stop the NBER from saying it started last month or earlier this month (with hindsight).
What the NBER does is a little like shooting at the side of a barn and drawing a target around the center of the holes afterward.
Also in agreement again I think, is that I'm not changing my allocations based on my prediction for May returns. A prediction I have little confidence in a that (55% confidence or 45% chance I am wrong). I'm not going to bet on those odds even if I am right about the odds.
From ChatGBT:
Broadly, from 1950 through recent years, May has been a modest month for the S&P 500. Historically, the index has averaged a return of approximately 0.2% in May, with a 61% probability of positive returns. However, in the past decade, May's average return has improved to around 0.7%, with nine out of the last ten Mays yielding positive results.​
I can't imagine anyone making market-timing decisions based on the NBER. I said we're in a recession because of the market's decline and GDP being negative for the first quarter. It's also likely to decline in the second quarter, which is the definition of a recession.
If Ray Dalio is right about the US going into a Depression, good luck holding equities through that. In the last Depression, the market declined 93%. However, I wouldn't use anyone's speculation about Recession or Depression either. My approach is 100% model-driven, and risk control is where I start when building a strategy. If you limit drawdowns, a portfolio's performance will double quickly and that's a HUGE advantage.
I feel that the combination of all the current administration's actions, including a sharp austerity push (DOGE), a multi-$trillion tax increase on the American people (tariffs), the economic benefit of legal immigration drying up (because people are afraid they'll be 'disappeared' to an El Salvador hell hole), and unemployment gaining steam (triggered by all the government layoffs), are tanking the economy and the market.
The trade war with China will leave store shelves empty in May. The 145% tariffs on China have already reduced trade by 40% (according to shipping traffic stats). As a result of all this, corporate income will decline sharply, and the market will reflect that decline.
However, all this about the economy is speculation and explanation: most importantly, my formula-based risk-control strategies have my portfolios mostly in cash since mid-late February. I will rely on those models to advise when to re-enter based on time-proven market-based measures.
Just my 2¢. In my opinion, what's most important is that investors have a strategy in which they have confidence and that allows them to sleep soundly at night. Protecting against drawdows using proven market-internal measures is what does the trick for me. But to each their own; that's what makes for a vibrant market!
Geov,
I just wanted to say I really appreciate you posting this. It’s so important to establish a baseline (or “base case”) before making any predictions — and you’ve done that very clearly here.
Those are some strong historical numbers — a 61% probability of positive returns for May over the long term, and even stronger more recently — that I wasn’t fully aware of until you shared them. If it actually mattered, I would probably adjust my prediction above based on the information you provided.
In any case, I think you’ve highlighted a crucial principle: before making any forecast, it’s critical to know what the base case looks like. Thanks for the reminder!
Yes, it's good to check on the monthly trend of the S&P 500. One could do this for every months of the year and then design an investment model accordingly, i.e. more risk or less risk depending on the historic monthly performance.
So for May less risk is appropriate. Remember the old saying: "Sell in May and go away".
Fun fact: The sum of market moves for the recessions mentioned above is -80.3%. So the mean and median of the moves are significantly different. While the median move is positive, the mean (average) is negative. This doesn't really help me feel comfortable about our current situation.
I really haven't changed course or put a hedge in place yet. I want to study the multiple causes of recessions, how they relate to our current situation, how the political drivers might play out quickly, and see if I can comfortably adopt a stance that's likely to be any better than doing nothing. I got hurt by bailing to cash at the start of the COVID meltdown then missing the rapid market turnaround. If I had stayed in stocks, I would have been up 20% more within months. Call me hesitant!
I can understand you very well. I remember my thoughts during COVID meltdown: 'This is the end of the world. The economy will collapse. The market will not recover for a long time'. But it was only for a while...
What I do during these times? I use my cash reserve to buy the most ugly, illiquid but highly ranked micro caps. This is also the time when illiquid stocks became more liquid due to selling pressure. There is not better time to go shopping ;]
On the other hand, I'm a bit contrarian from nature, so during times when market goes up and vol is low, I hedge a bit my portfolio against tail risk accumulating long spy puts and gld calls. So my returns may be below benchmark during prolonged market rally. And then during the next global stock market bloodbath, I use cash proceeding from options to buy equities.
I'm not sure if this the best strategy for everyone. It may not be the most profitable but I feel comfortable with this approach.
What will happen in May ? I do not know. I do nothing with my portfolio.
@pitmaster you said "On the other hand, I'm a bit contrarian from nature, so during times when market goes up and vol is low, I hedge a bit my portfolio against tail risk accumulating long spy puts and gld calls."
Can you define what goes up a bit means ?
In general if you hold long options when vol is low you lose money, so the key is to minimise period of holding options - search for a moment when time to bloodbath is close but options are still relatively cheap, market is overheated, sentiment is high + pay attention to changes in correlations.
I use metrics that are not available on P123 and preform daily simulation in python.
Below are two simplified strategies that trade volatility using VXZ.
I use the first approach for my real trading - I hedge when market goes up /calm and vol is relatively low but I use more complex strategies using spy puts and gld calls.
These simulations may be a bit overfitted. You may cross-validate them VXX etf. Be aware also that the VXZ was launched in 2019. Therefore the data before this period is simulated by P123
Below is a book when you combine both sims.
Edit: switch rebalance to 'daily' and you get slightly different results.
Unfortunately the 'BUY HIGH' strategy is definitely more profitable and stable using VXZ.
Thank you everyone for sharing your methods. I have never bought an option and can’t share any methods of my own.
But just to follow the discussion — they are both hedges, but what Pitmaster and Yuval are doing seems very different, with entirely different skills required.
Some timing in Pitmaster’s strategy, and Yuval’s being something more like a long/short strategy that identifies weak companies to place put options on?
I’m not commenting, as I have no experience — just noticing a significant difference. I hope to use one or both of these strategies in the future, but I’m not sure yet which would be right for me.
I have a SEP-IRA, and if I were smart, I’d use short positions or options in my taxable account and take any tax losses against gains in my SEP-IRA (or capital gains elsewhere). There seems to be real potential if losses can be used as part of a tax optimization strategy — so I definitely like the ideas being presented.
If I had a comment, it would only be that I can be a bit lazy at times — and that I’ve been slow to adopt one of these strategies. This is an interesting discussion — and one I’ll probably learn from and use at some point.
Doesn't Ray always say things like this?
As long as we’re discussing Ray in the context of different ways to manage risk:
Ray was constantly hedged — primarily through risk parity.
The largest hedge fund in the world (Bridgewater) used options at times — but the foundation remained risk parity, combined with selective leverage on TIPS and other defensive assets depending on the environment.
There was some timing involved too — for example, Ray moved away from TIPS when interest rates were near zero, recognizing that the risk/reward had shifted. Also, risk parity itself involves a kind of timing: position sizes are systematically adjusted based on the volatility of each asset.
He no longer controls the fund, but he had already markedly reduced the use of TIPS before stepping down.
Flexible — and never tied to just one approach to managing risk.
Jim,
Bridgewater remains the hedge fund with the largest AUM because other large players like Citadel and Millennium has closed to new money and constantly return profit(cash) to investors to keep performance above a certain threshold.
I think we have both discovered that risk parity is not really profitable before (throught the ETFs).
Pls refer to the article below about risk parity from CAIA. (equivalent of CFA in hedge fund).
Regards
James
August 9, 2024
sefa ozel-iStockPhoto
By Michael Edesess, Ph.D., Managing Partner / Special Advisor at M1K LLC.
Few practices in the business world are as absurd, senseless, irrational, and cynical as the allocation of investments of large public pension funds and endowments. And few fail so often and so predictably to achieve their true objectives. Yet almost all outside the industry – and many inside it – are fooled into believing the opposite. As an example, let us consider the recent news of the disappointing investment performance of Bridgewater Associates.
In late April, news reports appeared of clients’ dissatisfaction with the poor investment performance of the largest hedge fund in the world, Bridgewater Associates. Bridgewater, with $97 billion of assets as of June 2023, made its founder and chief investment officer Ray Dalio a famous multi-billionaire.
Most people assume he is a savvy investor who produces high investment returns for his exclusive institutional clients. (Bridgewater generally requires clients to have a minimum of $7.5 billion of investable assets.) And they assume that those clients, being “financially sophisticated,” must achieve high returns in the funds they invest in.
But that is not the case.
Bloomberg news reported on April 23:
It was an irresistible pitch. Give us your money, executives at Ray Dalio’s Bridgewater Associates and other hedge funds said, and we’ll funnel it into a money-minting, sure-thing strategy for the long haul. But now, after five years of sub-par returns, many of the institutional investors who sunk large sums into risk-parity funds, as they’re known, are demanding the money back.
Bridgewater’s much-touted All Weather fund uses the risk-parity strategy, as do many other hedge funds.
Let’s put some actual numbers on their abysmal performance. “Sub-par returns” is an understatement.
Risk parity was supposed to perform better than a 60/40 stock-bond mix. The benchmark it is compared to is a combination of 60 percent in the MSCI ACWI IMI index (global equities) and 40 percent in the Bloomberg Global Aggregate index (global bonds).
Bridgewater and the other hedge funds that practice risk parity, according to Hedge Fund Research (HFR), had appallingly bad investment performance relative to that benchmark. The numbers in the Bloomberg article show that for the 10 years 2014-2023, an investment in a simple 60/40 portfolio would have enjoyed more than twice the gains of an investment in a risk-parity portfolio. The 10-year return on Bridgewater’s All Weather fund was 43 percent and the 10-year return on the average risk-parity fund was 42 percent. Meanwhile, the 10-year return on a 60/40 portfolio was 90 percent.
This makes a very big difference to a large institutional fund, such as a multi-billion-dollar public pension fund or endowment fund. The difference between a 90 percent return and a 43 percent return can be hundreds of millions or even billions of dollars.
And yet, myriad papers – not only those published by the hedge funds themselves, but those published by academics in finance departments at universities – touted the benefits of risk parity. I will soon examine what those benefits were supposed to be. But first, let us explore the motivation behind those claims.
In the field of economics there is a theory called principal-agent theory. Investopedia defines the principal-agent problem in this way: “The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf.”
The problem arises because the self-interest of the agent – the person or group authorized to act on the principal’s behalf – may be different from the self-interest of the principal, the person or group who authorizes the agent to act on their behalf.
For example, a principal (the shareholders of a company) authorizes an agent (the management of the company) to act on the principal’s behalf. The implied agreement is that the agent is authorized to act only in the interest of the principal. But the agent also has their own interest at heart. That interest may conflict with the interest of the principal.
This can become a serious problem when there is substantial asymmetric information; the agent has more information about the workings of the endeavor than the principal. The agent can manipulate that information in such a way as to keep the principal unaware of exactly what is going on. The agent can do so in such a way as to direct profit to the agent rather than to the principal.
The agent can even create asymmetric information by adding a layer of complication to reports to the principal. This layer of complication can be legitimized through the formation of a society of agents of a particular type – a society of, say, chief financial officers – who create their own jargon and their own methodologies that are opaque to their principals. The agents therefore need to explain it to their principals, but their explanations may still be confusing. However, because the jargon and methodologies the agents use are legitimized by their respected society, the principals are forced to accept them.
It would be risky for the agent to be evaluated by the principal on the basis of bottom-line results of which they may not have complete control. Therefore, the agent creates a different and more arcane set of metrics on which to be evaluated – metrics that are certified by the society of similar agents, who may meet at conferences to converse in their jargon, and write papers in that jargon in peer-reviewed journals (papers reviewed by peers who are in the same society).
The investment of institutional funds like pension and endowment funds is a perfect setup for enabling the principal-agent conflict. However, the institutionalization of the society of agents is so tight, so well developed and de facto legitimized, and the principals are so distant, that the agents continue to get away with bleeding the principals.
Who are the agents? They are, essentially, a conspiracy of fund administrators, institutional investment consultants, fund managers, and finance academics (many of whom are themselves, in the role of consultants, on the payrolls of the consulting or investment management organizations) – all of whom are very highly compensated out of the corpus of the funds they are supposed to manage.
Who exactly, are the principals? In the case of public pension funds it may not be perfectly clear who “owns” them, but it is clear whose cash inflows fill the funds. It is the US taxpayer whose cash inflows fill them. Public pension funds are created to fund the retirement benefits of government employees. Those public employees’ salaries, and their pensions, are funded by the US taxpayer. And yet, how many taxpayers are aware that they are paying, on average, $500 a year in taxes just to pay the managers of those funds, the managers whose investment returns, like Bridgewater’s and other risk-parity managers, underperform the simplest possible investment strategy, namely investing in an index fund.
In the case of university endowment funds, again, “ownership” may not be perfectly clear, but they are funded mainly by the contributions of donors, as well as by tuitions and grants. And yet, there has been only one instance of a major donor suing a university for its endowment fund’s poor performance, poor performance that the donor had explicitly and repeatedly warned would occur if the endowment fund kept pursuing its high-cost strategy.
Fund trustees should put a stop to this theft, but they are confounded and hoodwinked by the jargon and opaque methodologies and the fact that proposed strategies, like risk parity, are the subject of peer-reviewed academic papers and conferences – and frankly, trustees themselves are paid handsomely out of the same funds, thus benefitting from this conspiracy.
Because the principals – the contributors to the funds – are so blasé about it, the agents can, in effect, get away with murder; or rather, in this case, with making off like a bandit with a substantial portion of the funds.
Many of these agents – the investment management companies and the institutional investment consultants – like to say, not without a certain smugness, that the investment strategies they recommend are “evidence based.” However, the evidence overwhelmingly shows that nothing undermines investment performance as much as the fees paid to money managers, consultants, and fund administrators. The evidence very clearly shows that minimizing those fees should be the number one goal of the fund’s investment strategy. Yet pension funds and endowments are doing the very opposite; they are virtually maximizing fees.
High fees are the main reason the Bridgewater fund and the other hedge funds using a risk-parity strategy performed so badly. Their underperformance relative to the 60/40 index portfolio amounted to about three percent annually. Of that three percent about two percent went to fees and other compensation. A 60/40 index portfolio by contrast could have been had for one-hundredth of those costs.
I said that in the principal-agent situation, the agent doesn’t want to be evaluated on their bottom-line results, because they may have too little control over those results. As such, it would be very risky to be evaluated on them. The agent creates other metrics on which they claim it is more important to be evaluated.
For investment management, the bottom-line result over which the agent has little or no control is investment return. In the case of the risk-parity strategy, the concocted metric is diversification. In the original development of modern portfolio theory by Harry Markowitz, increased diversification lowers risk. But the diversification of the risk-parity promoters is not Markowitz’s diversification. It is something else. It is not clear exactly what it is because it is never clearly defined. Nor is it clear why it would lower risk – and in particular, it is not at all clear why it would increase investment return, which is, after all, the investor’s bottom line.
The risk-parity argument says that in a 60/40 stock-bond portfolio the stock portion bears most of the risk, much more than 60 percent of it, because stocks’ returns vary more widely than bonds’. Therefore, the argument goes, to spread the portfolio’s risk “budget” more evenly across asset classes, the portfolio should contain much more bonds than stocks, enough more so that the variabilities of the stock portion and the bond portion are the same. This can be done without reducing expected return by leveraging, i.e. borrowing to invest more in bonds. An increased allocation to bonds will do well when interest rates are falling (such as the historical period over which the risk parity study was done) but poorly when interest rates are rising; an “All Weather” strategy it is not.
Why it should benefit the investor’s bottom line in the long run is not made clear. But a certain stamp of approval was placed on it by the society of investment management professionals because papers were written about it and conferences held. And, of course, there was – there always is – a study showing that historically, a risk-parity portfolio would have outperformed a 60/40 portfolio. But other papers claimed that the methodology of that study was flawed. And there is, in fact, considerable reason to believe that virtually all linear regression-based studies in the investment finance field are wrong.1
The way the investment of institutional fund portfolios is practiced is not in any sense illegal, but it is nonetheless spectacularly corrupt. Yet it seems to be impervious to correction. If it were truly done for the benefit of the principals, a very large number of the most highly paid financial workers in the country would be thrown out of jobs. This is not likely to happen.
But what is most distressing is not just that these people are earning such high levels of compensation, but that they are widely admired and even lionized for what they do and for the money they make, because it is not widely understood what they are actually doing. This needs to change. There is much talk about how many people lack a good financial education. That education should include frank and factual information about this industry.
1 See “Alphas and the Choice of Rate of Return in Regressions”; Edhec-Risk Institute Research Insights, June 2014.
