05 Jul 2018 4 min read

When swimming naked becomes embarrassing

By Emiel van den Heiligenberg

“You only find out who is swimming naked when the tide goes out” (Warren Buffett, 2001). In bull markets, market risk is often the most important driver of performance. However, we should pay attention to bottom-up investors in both equity and credit markets as they can add value in spotting turning points and identifying areas where investors may find themselves overexposed. 


I recently caught up with my old boss and mentor, William de Vijlder, currently the Chief Economist of BNP Paribas and a keen blogger himself. Discussing the economy and markets with William is always fascinating. Not your usual talking head, William has a rare talent of being able to translate complex academic concepts into simple, tangible narratives.

In his typical fashion, William pointed me towards a very interesting article on the way stock markets translate news in up and down cycles by researchers Martin Schmalz and Sergey Zhuk. The authors' main finding is that micro or stock-specific information is more relevant during a market peak - moving into a bear market - while macro information is the significant driver during a market trough - moving into a bull market.

This conclusion is both sobering and encouraging for me as an asset allocator. Both signals (micro and macro) work, but at specific points in the cycle

For instance, stocks react up to 70% more strongly to earnings news in downturns than in upturns - something we've seen in action this year - as documented by my Active Equities colleague, Nigel Masding. This means two things: 1) Volatility is counter-cyclical, i.e. it goes up in bear markets, and 2) Stock returns are negatively skewed, meaning equity markets tend to rise slowly but retrace quickly. 

The chart below shows the number of down months (-12% or more) versus up months of the S&P over the past 90 years, showing the negative skew of the S&P index. Big drawdowns in the S&P are much more frequent than big melt-ups, a typical phenomenon for equities. 

It probably also means that we can only put a limited amount of comfort in our fundamental economic research when predicting the next downturn, as the information value lies in more micro information

Schmalz and Zhuk suggest that “revelation risk” builds up during upturns and this risk gets resolved “when the tide goes out”. This idea suggests that investors are willing to cut corners and paper over cracks when the market is rising and business conditions are favourable. Liquidity is amply available during these times, with market beta often the most important driver of performance.

This causes stocks to get bid up to often unreasonable levels and investors to look at business models and performance in the short/intermediate term. In up markets flawed business models show decent profits. On the other hand, when business conditions worsen and the stock market corrects, it is much easier to see who truly has a good business model, who manages risk well versus who is just getting lucky during the boom times.

From these findings, we can draw the following conclusions: 

  • Active managers should have more ability to outperform in downturns. Although this is the conclusion from a range of academic research (Moskowitz, 2000; Kosowski, 2006; Sun, Wang, and Zheng, 2009; Glode, 2011). Jenter and Kanaan (2015), it is not evident in some recent more practical work from my teammate, Justin Onuekwusi
  • Especially when anticipating a downturn, we should pay attention to bottom-up investors in both equity and credit markets as they can add value in spotting turning points and identifying areas where investors may find themselves overexposed
With this in mind LGIM has created interdisciplinary thematic research groups that specifically aim to do just that: combining macro research with bottom-up credit and stock specific insights

As I noted in my previous blog, the butterfly effect, the odds are stacked against investors trying to time a market crisis, even though the eventual crisis might be inevitable. However, a better understanding of the transition mechanisms that lead to a crisis can lead to a crucial information advantage that allows us all to be better prepared for and navigate the next crisis.


Emiel van den Heiligenberg

Head of Asset Allocation

Emiel is responsible for the overall strategic direction of the team’s investment and business strategy. He claims to have been a promising lightweight rower at university until French fries got the better of him. Reflecting his love for rowing in a team, he firmly believes that excellence can only be achieved by a great team made up of motivated individuals that are also eager to work together. To this end he is the self-proclaimed inventor of the verb 'teaming' to acknowledge that shaping a top team and culture of excellence is an ongoing process. Outside of work-family obligations, Emiel’s spare time is filled by a passion for shark diving and skiing. Prior to dedicating his career to portfolio management in 1996, Emiel worked as a policy adviser in the Dutch Ministry of Finance and he graduated from Tilburg University in the Netherlands ages ago. When not glued to his Bloomberg screens, this Dutch man is hooked on computer games, peanut butter and his favourite dark beer made by Belgian monks.

Emiel van den Heiligenberg