Archive for November, 2011

Surviving Market Crashes, Part 3: The subprime mortgage crisis

Saturday, November 19th, 2011

In the previous two articles on surviving market crashes (“Surviving market crashes” and “Surviving market crashes, Part 2: The dot-com bust“) we looked at how Modified Modern Portfolio Theory (MMPT)–an innovative modification to Modern Portfolio Theory (MPT)–provided asset allocation recommendations that resulted in the investor not only avoiding the bulk of losses during market crashes but, in the case of the dot-com bust, actually producing a substantial positive return.

This article is a continuation of the same theme, but here, we’ll be looking at something that wreaked more havoc on portfolio returns than did the dot-com bust—the subprime mortgage meltdown from 2007-2009. We shall show that MMPT-based portfolios again produce superior returns at much lower risk than their classic MPT-based counterparts.

Summary of the MMPT methodology
Since the MMPT methodology was explained in the first two articles, the reader is referred to those for the detailed explanation. Briefly, the approach applies a robust market-timing scheme to Modern Portfolio Theory to determine when one should allocate funds to a particular asset class and when one should take money out of that asset class and place it in the safety of the risk-free asset class (cash, insured money markets, or T-bills).

To illustrate fund performance, nine of the most commonly used asset classes form the basis of the our model investment portfolio: large-cap stocks, small-cap stocks, long-term investment grade corporate bonds, long-term government bonds, intermediate-term government bonds, real estate investment trusts (REITs), international stocks, international bonds, and T-bills (or some other risk-free asset class). Gold and other precious metals are not included for reasons given previously (although we could add it if so desired since we have the gold database).

The devastation of the subprime mortgage crisis
The time frame we’ll be using in this analysis begins on October 11, 2007 when the S&P 500 hit an intraday high of 1576 and ends on March 6, 2009 when the S&P 500 reached its intraday low of 667. This represents a loss of over 57%, more than the 50% loss suffered during the dot-com bust. Figure 1 (which includes dividend income) illustrates just how steep this plunge was.

Figure 1. Total Return Derived from the S&P 500

Along with a steeper loss in the large-cap stocks, the mortgage crisis took a major toll on small-caps as well with similar losses. This was not the case in the dot-com bust where the value of small-cap stocks actually held on despite large price fluctuations.

Figure 2. Total Return Derived from Small Cap Stocks

Table 1 below shows that the annualized returns for all asset classes except for government bonds did poorly during this time period. Comparing these returns with those during the dot-com bust (refer to Table 3 in the previous article), we can see that everything except for government bonds fared much worse during the subprime crisis especially REITs which went from a +7% return to a whopping -54% loss.

Table 1: Annualized total returns of all asset classes during the subprime mortgage financial crisis

Portfolio allocations during the mortgage meltdown
As in the previous articles, we are requiring a 10% compounded return for our model portfolios. Portfolios are rebalanced monthly as new total return asset class performance data is made available. The portfolio allocation tool used for both approaches is the SMC Analyzer.

Table 2 below shows that a classic MPT portfolio would have had roughly 60 – 80% of their assets allocated to equities with the rest divided between REITs and corporate bonds. Table 1 above shows that it is exactly these asset classes that fared the worst during this time period.

Table 2. Classic MPT Historical Allocations During the Subprime Mortgage Financial Crisis for a Target 10% Compounded Annual Return

By comparison, the MMPT equivalent portfolio (Table 3) was already light in the large stock asset class, having benefited from the experience of the dot-com bubble collapse. For the entire period of the subprime meltdown, the MMPT portfolio was heavily weighted (70-100%) towards medium-term government bonds and T-bills with some minor exposure to small-caps and international equities.

Table 3. MMPT Historical Allocations During the Subprime Mortgage Financial Crisis for a Target 10% Compounded Annual Return

As Table 1 shows, it was this exposure to the equity classes that caused the most harm to both portfolios. It’s interesting to note that long-term government bonds fared the best in a so called flight to safety but MMPT did not allocate funds to it instead preferring the historical lower volatility (risk) of the intermediate-term bonds.

Comparison of portfolio returns
During the months of the dot-com bust, the MMPT portfolio lost at a rate of only 1.1% compounded annually (green line in Figure 3 below) while the classic MPT portfolio lost money at an annualized rate of -32.9% (magenta line). Further, the MMPT portfolio was much less volatile. It experienced a standard deviation of only 4.8% while the classic MPT investor was being whipsawed to the tune of 17.3%. Sure, suffering a small loss isn’t desirable but it’s certainly a lot more palatable than losing a third of your holdings. Which scenario would you have chosen?

[As an aside, I attended a conference of public fund and hedge fund managers who actually admitted to losing between 25 and 50% of their funds’ assets during this period.]

Figure 3. Comparison of results
(green = MMPT)
(magenta = MPT)

We have shown that an MMPT investor during the subprime mortgage financial crisis was able to keep almost all of his money while most other investors were getting clobbered. The reason is that a judiciously and properly applied market timing approach injects an element of nimbleness and reactivity to a portfolio while still benefiting from historical experience. This is of tremendous value especially in today’s uncertain markets.

Every day the news concerning the deterioration of the global economy is increasing volatility across most of the traditional asset classes, and it’s for this reason that market timing approaches should be given their proper due. I believe we have shown with these case studies that the MMPT approach combines the best of Modern Portfolio Theory with the desirability of a viable market timing strategy.

For further information on how you can save your nest egg from the devastation of market crashes, please visit our website.