March 18, 2014 | Market Commentary Market Commentary, MV Financial Research Insights | Masood Vojdani & Katrina Lamb, CFA
MV Research Insights: The Anatomy of Pullbacks
In risk asset markets the occurrence of a significant pullback is nearly inevitable: sooner or later, the market will give up a sizable chunk of the gains it earns during periods of growth. There is much debate in the investment community about how to manage pullback risk: when to go defensive, and when to stay firm.
In our view the most important determinant for managing pullback risk is context. Pullbacks have different characteristics during extended growth markets than they do when the market undergoes a periodic reversal. “The Anatomy of Pullbacks” focuses on the key pullback characteristics that manifest differently in growth and reversal market contexts.
The most telling context, in our view, is the macro market trend. There have been only five macro contexts since 1929: two macro growth environments, and three macro reversals, or gap markets (see Chart 3 on page 5 below). The S&P 500 and other major U.S. indexes broke out of the latest technical reversal in 2013: we are currently either in the early stages of a new macro growth trend, or a false dawn that will at some point revert to the macro reversal. Historical patterns suggest the growth trend, but of course there can be no certainty.
For core U.S. equities, we define a cyclical pullback event as one with a magnitude of 5% or more from the previous peak closing price to the trough close, followed by a recovery of at least 5%. Since 1950 there have been 176 such pullback events on the S&P 500 (i.e., 176 5%-plus pullbacks followed by 176 5%-plus recoveries). These occur within extended secular bull and bear markets (using the accepted technical definition of a 20% peak-to-trough reversal to indicate the bear), which in turn are part of the larger macro growth or reversal context.
We measure the impact of pullbacks by their magnitude (how deep), duration (how long), and frequency (how often). Another important measure for understanding the larger context of a pullback is momentum; i.e. where daily closing prices are relative to longer term moving averages of the closing prices.
Risk in asset markets is asymmetric: downside risk tends to be more concentrated and pronounced than upside risk. Elevations in baseline risk (e.g. as observed from an asset’s standard deviation of short term returns or a market proxy like the CBOE VIX index) can provide warning signals about the potential for near-term pullbacks.
In-depth analysis of pullbacks in prior growth and reversal environments gives us insight about when going defensive can make a real impact on preserving capital, and when it is likely to achieve nothing more than miscalculated timing and lost upside opportunity. Predictive analytical models that evaluate price, risk and momentum signals can help portfolio managers make informed, contextually appropriate decisions.