Predicting the bear

December 23, 2019

Predictions, projections, and prognostications of an impending recession and accompanying bear market in stocks have been building for a while now. The reality is that global stock markets, and U.S. markets in particular, have been in a bull market cycle of historic duration and intensity since the recovery from the financial crises a decade ago. The thinking is that it this bull market has overstayed its welcome and has to stop at some point. But is that turn imminent?

There are certainly red flags, whether the ongoing trade wars, the impeachment process in the U.S. coupled with the 2020 election, or the general slowdown in the global economy. It is interesting to talk doom and gloom, but for the most part, that’s all it is, just talk. Unless, that is, you are a professional money manager with a reputation and millions of dollars on the line.

To get a better fix on managers’ thinking, I researched fund holdings to see if there is any indication we can glean, one way or the other, about the direction of the equity markets. For instance, if fund managers are shifting away from equities, that would be an indication of rising negative sentiment.

The best way to do this is to look at balanced funds, because they generally have the most leeway in terms of shifting asset allocations. Equity funds are generally stuck to holding at least 90% equity, and fixed income funds are usually going to be around 95% in fixed income regardless of market conditions. But balanced funds have room to shift allocations among asset classes, especially in terms of fund categories as defined by the Canadian Investment Funds Standards Committee (CIFSC).

By CIFSC definition, balanced funds are grouped into three buckets: Equity Balanced – where equity holdings are between 60% and 90%; Neutral Balanced –equity holdings between 40% and 60%; and Fixed Income Balanced –equities between 5% and 40%. There is also a Tactical Balanced category, probably the most interesting for this exercise, intended for funds that shift allocations beyond the 60%-40% thresholds. Hypothetically, these funds could go from 40% equity (or lower) to 60% equity (or higher) over time.

The accompanying graph shows the average equity allocation in each of the three Canadian balanced categories (lines, left axis), as well as the monthly returns of the S&P/TSX Composite Index (bars, right axis).

There are three significant points on this graph showing a downward trend in equity allocations: 1) starting in March 2011; 2) starting in May 2014; and 3) starting in April 2018. All three Canadian Balanced categories show decreases in equities over these periods, but the most significant changes, and again the most interesting category for this exercise, are in the Tactical Balanced funds, so I will focus on those.

The accompanying table summarizes these three periods for the Tactical Balanced funds and the TSX.

In March 2011 and May 2015, the fund managers got it right. The decrease in equity allocation came before significant market corrections. Starting in March 2011, the S&P/TSX Composite had seven consecutive negative months, and equity allocations went to 47.6% from 64.3%. In May 2014, the shift away from equities was more gradual, spanning 23 months, a period where the S&P/TSX Composite had 13 negative months and lost 7.6%. In this period, there was an 18% drawdown in the S&P/TSX between August 2014 and January 2016.

On the other hand, starting in April 2018 managers began reducing equity exposure over 17 months, shrinking to 47.5% from 57.9%, a period when the S&P/TSX rose by 5.3%. Based on the severity of the shift, you could say there was less conviction this time relative to the others, which may be attributed to the mixed messages we get from the U.S. Still, it is hard not to conclude that managers were expecting a correction that did not happen.

To be fair, there was a 13% drawdown in the period from July to December 2018, so maybe a better conclusion is that managers expected a more severe correction as equity allocations increased slightly in January 2019 but then continued downward until August 2019. Equity holdings increased in September and October and were back up to 51.5% as of Oct. 31.

I would not expect funds’ equity allocations to continue rising through early 2020, because there is just too much uncertainty hanging over markets. It is more likely that a conservative approach will prevail, at least in the early part of the year, but it will be interesting to track managers’ sentiment as the year progresses.

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