How to Make Money in a Bear Market. Part 1.

It's about buying what others are afraid to. Backtested to 1974, through 8 crisis events - 144,641% total return

This is going to be more about aggressive investing than it is about hedging. I'll walk through a fund we built at Quantbase quite recently that has backtested incredibly well in the last 8 crises (1974, 1980, 1986, 2000, 2008, 2012, 2016, 2020) while tracking the market when not in a crisis.

But first, a little bit about hedging :)

Alternative assets exist to make money when the traditional world isn't - at least from the institutional perspective, it's what they're usually good for. The concept of beta, or covariance with the stock market, is important to understand here. The beta of an asset with the market essentially means - when the market goes up, what is the multiplier of what this asset will go up by? If the market went up by 10% last year and is expected to go up by 10% in a year, an asset with a historical 1-year beta of 2.0 went up by 20% last year, and is expected to do the same this year. Most stocks, because they're, well, stocks, and will correlate with the stock market, will have a beta between 0.5 and 1.5. An asset with a beta of 0 will have an unpredictable return if you just looked at the stock market to predict its return.

The pitch for many alternative assets is to have low, zero, or negative beta - they're a hedge against downturns in traditional vehicles like stocks, because, as it's supposed to go, when stocks go down (and/or bonds), these asset classes move in a way that saves a traditional stock + bond portfolio from total downside.

That's the goal many an institution has in mind when investing in hedge funds and private equity (and what causes them to dump them sometimes when this reality doesn't play out in a crisis) - zero beta exposure, to have a source of returns outside of traditional stock market forces. That's because institutions are primarily focused on minimizing risk in their returns. Lower positive returns are acceptable because they come with lower risk.

Today, I want to discuss something different - taking on a bit more risk (investing in a cross-section of stocks in a bear market, instead of hiding out in cash) to get a lot more return. A smarter way to take on risk, when taking risk is the last thing on most investors’ minds.

We launched our Flagship Crisis Investing fund last week to our current clients, and made it live a few days ago to all new users. Inspired by research from a global asset management firm, this strategy does not flock to safety. Using 7 factors historically tested to outperform in bear market and volatile scenarios, this strategy invests in the S&P when not in a crisis, and when detecting a crisis, transitions to a rebalancing bear market portfolio for 24 months. It's done well in the 8 crises since 1974, and is currently still in the "crisis mode" effected from the COVID crash, and hugely outperforming.

The strategy, which hits its stride in the first 8-24 months of a crisis, relies on two assumptions: based on historical data, it can use an interest rate signal to detect an oncoming bear market, and that it can invest in the correct cross section of the broader stock market to beat the S&P in a downturn.

The Stats

• 144,641% total return since October 1974, compared to 5,515% for the S&P

  • This number looks huge, and it is. It comes from not having 50% drawdowns in bear markets.

• 0.75 daily Sharpe ratio over the entire period, including the drawdowns. This means that you're accepting some volatility for these returns. It's not a hedging portfolio, but an aggressive one

• Annualized return of 22.63% in the last 10 years. This is how it has performed in a largely bull market, that has been peppered by a few one-off volatile scenarios. The strategy, as it has been since 1974, does best in macro bear market environments like the one we might be going into, although it has also done well in one-off volatile events like the COVID stock selloff that lasted just a couple of months.

The Signal

When the high-yield spread - denoted as the difference between the Treasury rate and interest rates on junk bonds - hits 6.5%, we're in the start of a crisis. Wait for 3 months for the crisis to hit its panic peak, based on historical data, and then invest.

The 6.5% makes sense - this yield usually lies around 3-4%. Investors are willing to take the risk of junk bonds (bonds of not-great companies, usually) for 3-4% extra return, because in a good market nobody's going bankrupt. In a bad one - lots are, and investors won't buy the bad companies’ bonds unless they promise a larger interest rate on their bonds.

The Crisis Portfolio

An equal-weighted collection of 50 stocks, chosen by looking at how those stocks rank on 7 factors.

These factors are:

• High asset turnover (revenue over total assets)

• Positive net income

• Low trade volume

• Positive operating cash flow

• Are de-leveraging

• Have a currently high net debt over enterprise value

• Are a value stock

Empirical data and backtest show that stocks ranking highly on these factors do exceptionally better than the market over the 24 months proceeding a crisis. We'll dive in more next week on why these factors work so well and why they make intuitive sense - you don't want to use factors that don't make intuitive sense but just fit the data, because that's just playing around with numbers and statistics, not making investment hypotheses grounded in reality.

Well-known research posits that 20 stocks is enough to build a diversified portfolio, so why 50? Because we're taking on added risk in a bear market and by investing in often beaten-down small cap value stocks (more on that below), we wanted to diversify further into 50. This seems to be supported by the backtested data - historical returns for a 20-stock portfolio diverge further from the market (higher and lower than the 50-stock portfolio in different crises), the Sharpe is much lower. You're taking on more risk for the returns you might get, meaning there's a greater risk that your returns disappear in a more volatile, uncertain future scenario.

We rebalance every month - reweighting the largest movers back to their equal weights, and then rerunning our factor ranking mechanism so that stocks that no longer rank well (above 70 on a 100 point scale) are nixed from the portfolio. This allows for much less turnover than a system that simply rebalances into the top 50 ranked stocks every month, and also has similar returns and other statistics.

The strategy can be found here if you'd like to play around with more of the stats or make an investment yourself. Next week, an exploration of the specific factors that drive this fund's returns, and a dive into the small cap value effect, where we can outperform institutional hedge funds running a very similar strategy, due to the extended size of our investment universe.