Bear market strategies, Twitter style

In the investment world, social media is the town square for bull market braggards. Now the tide of easy money from central banks is going out, you can see which financial commentators have been swimming naked. Equally, there are plenty in the so-called ‘FinTwit’ community whose analysis and investment strategies appear to have paid off just as effectively, if not more so, than their Wall Street or City equivalents' own.

Viewing any source in isolation, especially one so notoriously fickle as social media, is not to be advised (Elon Musk isn’t wrong about the trust issues and preponderance of false accounts). But FinTwit can enrich the conversation, and at the very least, their voices can be weighed against those from the asset management and hedge fund industries that, in some cases, they left behind.

Macro maelstrom

That can be a valuable corrective at a time when policymakers are belatedly racing to clamp down on inflation - and in doing so lengthening the odds that they can engineer a ‘soft-landing’ for the economy as they withdraw the punch bowl of monetary stimulus.

Twitter investors were early to admonish central banks for being behind the curve on inflation, and some social media types have remained ahead of the curve in the past few weeks. Noting early last month that the growing prominence of higher housing costs was making US inflation appear stickier, some commenters predicted a more aggressive pace of tightening by the Federal Reserve.

One Twitter user in this camp was 'MacroAlf', aka economist Alfonso Peccatiello, once head of fixed income management for a large ING Deutschland fund and now an independent investor. He said the May US inflation report, in which headline price growth moderated for the first time since August 2021, "actually increases the probability the Fed will have to go with a non-linear, more aggressive hawkish rhetoric to slow down inflation”.

That forecast became a reality a month later when the central bank raised rates by 75 basis points. it may do so again later this month, before then taking its foot off the gas.

Drawdown control: has this bear fully shown its teeth?

Translating these predictions into investment strategies is what really counts, and many on FinTwit attempt to do just that. With some prominent names of recent times now sheepishly silent, insightful bear market strategies have moved to the fore.

In such cases there is the old stopped clock risk; those whose dogmatic views make them miss sizeable amounts of  upside feel vindicated in sell offs, only to get burned again in the rallies.  More dynamic asset allocators, however, are showing they’re worth their salt. Limiting peak-to-trough portfolio drawdown is the mantra of @WifeyAlpha – a handle set up by a professional quant trader in homage to @RealAlphaWifey, his partner. There is also a fair amount of attention lavished on the family dog, CQ (which stands for Chief Quant).

Wifey’s current tactical asset allocation comprises what is named the Pig portfolio (of mostly short futures contracts), cash (US dollars) and some long futures to hedge against bear market rallies. Colloquially known as ‘dead cat bounces’, these upside spikes that catch out short sellers are mitigated by the hedges: Wifey is disdainful of “permabears” who fail to take similar precautions.

Allocation changes in the portfolio are triggered by bespoke systems (the main one nicknamed VolQ).

Importantly, inexperienced investors are discouraged from trading derivatives: for them it is best to hold cash in a downturn. Futures are standardised contracts where the buyer agrees to purchase a security from the seller at an agreed date and price. There are costs to running the positions and, although private investors can buy futures, for most the complexity means it is not advisable.

“This is an inflationary bear market”, Wifey says over private DM (direct message), “the best thing [a regular investor] can do is go to cash. Shorting is hard and difficult for new traders. If you can master it, you will be able to produce alpha in a downward trending market. What I say is “capital preservation first, capital growth second”, always looking after your family funds.”

Whether you’re sitting tight with cash or a hedged trader, it’s about limiting risk: “5 per cent drawdown is your limit”, goes the rationale, turning “the bee stings into mosquito bites”. Malaria withstanding, that’s a good maxim for any investor.

Pigging out on alpha, but greed must have limits

The Pig portfolio is net-short equities, short bonds, short investment grade credit, short high-yield credit, short real estate, short mortgages and short bitcoin. What does that leave to be long? The answer is US Treasury bills and Treasury notes with less than five years to maturity, short-term Treasury Inflation Protected Securities (TIPS), gold, silver, the US dollar, Japanese yen and Swiss franc.

The strategy has been running for over seven months (with three VolQ-signalled rebalances), made a total return of 20 per cent, so far, and the maximum drawdown is -6.5 per cent. Transparency is important, and short commodity positions that were stopped out (i.e. when a stipulated protective loss threshold was breached), have been candidly highlighted.

Not being too greedy is crucial. Sacrificing some alpha when markets behave as anticipated, and the hedges lose money, is insurance for when adverse moves happen. For example, during the equity rally of 24 June, Wifey’s hedged Pig lost 50 basis points. The 318 bps gain for the S&P 500 index on the same day would have caused far greater damage to a purely short portfolio.

Such upswings are brutal for short sellers. Even if the fundamentals informing positions are sound; “the market can remain irrational for longer than you can remain solvent”, goes the adage attributed to John Maynard Keynes.   

Rationality will win out in the end, but for now markets are up and down like a yo-yo. A powerful downtrend resumed in mid-June before the spike higher at the end of the month. The Kobeissi Letter, a macro newsletter that is active on Twitter, tweeted recently that it expects the S&P 500 could regain the 4,000 mark via 10 per cent relief rally, but predicts selling will then resume in early July and trap bullish investors.

Citing the fact that, on average, bear markets since 1980 have had three plus-ten per cent bear rallies, @KobeissiLetter tweets “A bet on a bottom now is a bet against history”.

The world’s largest asset managers agree with fintwits the time to buy dips hasn’t arrived. BlackRock Investment Institute affirmed a neutral view on equities on a six- to 12-month horizon in its weekly market commentary published 13 June.

“Valuations aren’t much cheaper given rising interest rates and a weaker earnings outlook”, writes BII, adding that: “We also see a risk the Fed will lift rates too high – or that markets believe it will.”

More trouble brewing in bond markets

In many ways bond markets lead equities and clouds have been gathering for some months. Bonds pay a fixed coupon, so prices move inversely to yields as the market settles on a fair rate of return. When real yields are being eaten away by inflation, nominal yields are pressured to rise.

Linked to inflation, and arguably the biggest risk to developed government bond prices (assuming no fears of default), are interest rates. Central banks raise the cost of money to choke off demand and alleviate upward pressure on prices, automatically sending nominal yields higher.

Rate hikes, therefore, are bearish for bond prices. But although central banks sometimes fail to adequately telegraph their next moves, expected increases get priced in quickly. Harder to call is the level of price volatility that will be caused as central banks reverse quantitative easing and shrink their balance sheets.

Quantitative tightening (QT), as it is known, will effectively lessen the availability of central bank reserves and reduce liquidity in the financial system. Although the Fed’s QT is on an unprecedented scale, John Bellows, a portfolio manager at Western Asset Management, emphasises it is happening from a very high base and at a much slower pace than the monetary stimulus programmes seen over recent years. In Bellows’ view, therefore, the focus is rightly on rates.

The added uncertainty of QT is perhaps more acute in the eurozone, where the European Central Bank's withdrawal as a buyer for lower quality sovereign debt (Italy is the big worry), could have serious ramifications. Just a week after signalling QT intent, the ECB pledged it will be flexible to support sovereign bonds on the periphery of the eurozone, demonstrating it takes the risk seriously.

Italian bonds are a big concern for @MacroAlf. Another big macro risk on his radar is the quantity (roughly $3tn) of BBB-rated US corporate bonds that could, to paraphrase his words, become a no-go for institutions and kickstart a vicious cycle in corporate credit. All it takes is a spate of recession-driven downgrades to junk status. 

This is out of sync with the consensus view at asset managers. Franklin Templeton's research team, for instance, points to historically strong numbers - albeit ones that are now on a declining trend - in US non-farm payrolls as a sign recession isn’t imminent, potentially buying the Fed time to get a grip.  

Earnings worry for equities

Back on Twitter, Alf says that central banks tightening rates and embarking on QT at the same time economies are slowing is likely a recipe for volatility in asset markets staying elevated.

Real rates on government bonds fall for one of two reasons, explains Alf. Either because monetary policy becomes accommodative (the opposite of what’s happening now), or because investors are becoming more pessimistic. Downward revisions in GDP forecasts are part of a cycle of malaise and that’s beginning to feed through into weaker earnings per share estimates from equity analysts.

The S&P 500 fell firmly into bear market territory on 13 June, and the fundamentals are becoming less supportive of previously expensive valuations. Thinking in terms of the forward-looking price/earnings ratio, the initial problem investors had with the multiple being paid for US shares was the price. Now it’s the earnings in the spotlight.

To make matters worse, nominal interest rates are still going up. The expected rate of return for equity investors implied by future earnings and today’s share price is falling anyway, so it looks progressively less attractive relative to a rising yield on safe government bonds. Something must give to convince stock market investors they can make a fair excess return over Treasuries – ie, maintain the equity risk premium – so it’s likely the S&P 500 has further to fall despite the prospect of powerful relief rallies.

Playing these markets

Calling the bottom of a bear market when it is time to pile back into risk assets is incredibly difficult, and there are technical and fundamental reasons why investors should avoid being fooled by rallies that turn out to be short-lived. There is a balance to be struck, however.

Tactical asset allocation doesn’t usually entail being out of core markets altogether (investors don’t want to miss early upside in a new cycle), but it does mean taking a defensive tilt and being ‘underweight’ the usual strategic level of exposure. Diluting drawdown by holding more cash than usual is very important.

Not everyone can be a hedged short seller, but bear rallies are an opportunity to rebalance portfolios, then sit tight with reduced risk exposure until an inflection point is reached.

Volatility traders have become more noticeable in the FinTwit community although one of the better ones, @VolatilitySwan has recently flown the coop. It is worth keeping an eye out for a return: while on the platform, the account, which used the imagery of black swans in a nod to the uncertainties of investing, offered sage advice about judging when to tilt portfolios into more attractively priced risk assets.

Risk premiums, as mentioned, are the reward for holding assets with more unpredictable rates of return compared to the guaranteed yield on safe government bonds. As you’d expect, the premiums widen when there is more fear, so there is value to be harvested close to the bottom of bear markets. Doing so, however, has been likened to searching rubbish dumps:

“Nothing wrong with harvesting risk premiums, however, you must have a risk on/risk off filter if you want to harvest successfully. Knowing when it’s advantageous to dumpster dive and when it’s not.” - @VolatilitySwan 

Wifey’s VolQ algorithms have given no indication it is time to go risk-on, but when they do there are other animal-themed portfolios to rotate into more bullish asset allocations.

Following how trading strategies like Pig perform will be interesting, whether for those who are invested for the long-term, those who are sitting on the sidelines in cash waiting to rejoin the party, or those who are somewhere inbetween. As with any low ebb for risk assets, the potential rewards on the other side could be significant. Once the VolQ algorithms signal the stock market lows are hit, and value is cheap, Wifey believes “we will have the chance of our lifetimes to buy and hold for the next 20 years.” 

For an excel version of the following tables, click below.