Altering allocation to account for new risks

Fat tails are typically periods in a marketplace when market return standard deviation goes much wider than with a traditional norm. It gets the moniker from the shape of this event on a chart that tracks the standard deviation of returns, in which it creates a curve with wide-tail ends.

Sasveld’s first point was that high volatility is not unprecedented; investors are not entering uncharted waters. Working back to the Great Depression, investors will see there are historical precedents for some of the events happening now. Only that time period gives some template of what has happened to the debt markets where unprecedented default levels have been priced into non-government bond yields.

“The unwind of the dotcom bubble in the late 1990s would have been impossible to forecast on a monthly or even quarterly basis without appropriate weight given to the Great Depression,” he said. “The last year or two has essentially been a 100-year flood for credit. I think it’s excusable that asset allocators could—in regard to capital market expectations—build expectations that didn’t include Great Depression levels for investment grade credit.”

When it comes to equities, he said there have been plenty of precedents for the downturn.

“There is no excuse for saying this was ‘unforecastable’ on equities,” Sasveld said. “We’ve been here before in the 1970s; we’ve been here in the late 1980s; we’ve seen the unwind of the dotcom bubble and the Great Depression in the U.S. and U.K. [create three standard deviation events],” he said.

Still, with 70 years of market history, it’s difficult to determine just which market cycle is the most instructive for opportunities that may present themselves in the future.

Sasveld suggests that asset allocation strategists might want to ignore the period from 1966 to the mid-1990s, since the economic factors of today seem quite detached from the reality experienced during those 30 years.

“If you look at the period from the 1960s to the mid-1990s, I think you have to ask yourself whether that period is really relevant for the world of the near future, which looks at a dramatically lower interest rate regime for a variety of countries and a zero or negative fixed-income correlation to equities in virtually almost every market in the world,” he said.

Lower return expectations
Sasveld warned that, apart from a rally in equities from the bottom of this bear market, investors have to brace themselves for much lower risk premiums on equities in the future. This is partially due to the fact that national economies continue to stabilize over a long-term horizon.

“If you look at GDP volatility in each of the four major regions in the world, the three- year rolling volatility of real GDP has actually declined dramatically from the 1970s until now with one exception, which is emerging markets,” he said. “The current observations are troubling in that GDP volatility is rising. So it’s not necessarily a Goldilocks situation [of low inflation and moderate growth].”

Once economic recovery takes hold, there may not be the levers that existed in the previous bull markets to drive market returns to new highs—most notably, Sasveld pointed out, there will be less leverage, less of a “functioning” banking system to facilitate financial growth.

Industrial production in countries like Japan continues to plummet, so the ability of industrialized economies to fuel real growth at a torrid pace seems unlikely.

In fact, even during the last two big bull markets, Sasveld pointed out that real income growth for companies was nowhere near their earnings per share (EPS). He compared the S&P 500’s operating EPS to the National Income and Product Account (NIPA) earnings, and found real earnings growth was fairly flat.