How much is enough?

In a selloff, investors are vexed by the question of when to buy. We measure historic Asian market draw-downs and future returns once stocks have fallen threshold levels (market, country and sector). Historically, beginning to accumulate Asian stocks when selloffs have reached current levels, has on average been an attractive strategy on 1, 2 and 3 year timeframes.

How much is enough?

At the time of writing the Asia ex Japan benchmark index is down around 26% from its peak in January this year. While we could debate the myriad potential factors contributing to this selloff, this brief paper addresses one question:

“How far does the market need to drop so an investor can buy in anticipation of the future recovery?”

Again, there are untold macro and microeconomic factors that drive the ultimate answer. Many of these may only be evident after the fact. This note makes no attempt to address any of these, other than implicitly. We simply take the available history of Asian market selloffs and measure future 1, 2 and 3 year returns after the market has fallen a threshold level; e.g. historically, if I bought the Asian market after it had fallen, say, 30%, what was the average return over the following 1, 2 and 3 years? Is 30% enough, or do I need to see more downside first because the risk of further falls is too high? So in essence, and in a grossly simplified manner, we are seeking signs of at what point investors go too far and the sell-off begins to extend beyond what may be justified by macro and microeconomic considerations.

Table 1 provides the 5 largest drawdowns for the MSCI Asia ex Japan index using daily data back to 31 December 1987. The table displays the peak to trough return fall, the total number of days the drawdown lasted, the number of days from peak to trough and the number of days from trough to full recovery of the drawdown return. Table 2 provides the same information for the MSCI Asia ex Japan Small Cap index from 31 May 1994. It is clear in both tables that maximum drawdowns can be severe; the largest for the large cap index was –69.5% and the largest for the small cap index was –75.7%.

However, we know it is virtually impossible, other than by luck, to perfectly time market peaks and troughs. It therefore makes sense to begin accumulating stock in a selldown as that selldown extends. While the market may fall 60%+ in a selloff, that does not preclude buying earlier in the selloff and profiting from the recovery over the following 1-2 years+, even if the true bottom is much lower.

To address the question of when to begin buying in a sell-off (at least in the context of historical evidence of such), we take drawdown data for the Asian market and separate it into buckets representing threshold selloff levels; e.g. identifying every day in which a peak to trough (to date) drawdown is –20 to –30%, or –30 to – 40%, etc. We then calculate the 1, 2 and 3 year returns (not annualized) if an investor was to buy at the close of that day, and we the calculate summary statistics for all of those observations (average returns, median, standard deviation and first quartile = 25% of observations were below this level).

These results therefore represent the historic returns to an uninformed strategy, simply buying the market when it has fallen a threshold level. It consequently reflects investor uncertainty regarding the ultimate magnitude of the selloff, but provides some indication of when a selloff has become over-extended and/or where the likely recovery magnitude and timing are sufficiently large and near to warrant buying.

Table 3 summarises results for the MSCI Asia ex Japan index and table 4 provides the outcome of the same analysis applied to the benchmark small cap index.

We see that, not surprisingly, the largest falls are associated with the largest recoveries. We know from table 1 that the maximum drawdowns were –60 to –70%. In table 3 we see that a strategy of buying any day in which the drawdown had reached more than –60% saw average future 1, 2 and 3 year returns of 60.4%, 74.7% and 70.0%, respectively.

The Asian benchmark is currently close to the –30 to –40% range. Historically, if an investor was to buy the index at the close of any day in which the drawdown had reached such levels (with no knowledge whether the drawdown had bottomed or would extend further), the future average 1, 2 and 3 year returns were 7.3%, 15.8% and 22.4%. Median 1, 2 and 3 year returns were 14.6%, 15.4% and 18.1%. It is likely fair to say that by many investors’ standards these are attractive returns and provide support for beginning accumulation of stocks once the market has fallen to this extent.

This is not, however, a riskless strategy. We also see in table 3 that 25% of future 1 year returns were below -3.5%. Buying the market after falls of –30 to –40% was not historically a guaranteed profitable strategy, but the results do provide evidence that beginning to build positions at such levels has been an attractive approach.

Future returns for small cap stocks (table 4) in the –30 to –40% range are much stronger than those recorded for large caps. Future 1, 2 and 3 year average returns were 27.6%, 24.2% and 10.0%, respectively, if the small cap benchmark was purchased anytime its drawdown reached this range.

However, the first quartile levels in table 4 for drawdowns of –40 to –50% and –50 to –60% highlight, again, that this is not a riskless strategy. There is significant potential for the drawdown to extend further and thus some caution is warranted. The data supports gradual accumulation, historically, when small cap drawdowns reach current levels, but moving slowly and being willing to pause if the selloff displays evidence of undergoing extension. Looking at the underlying data, the accumulation strategy would have been successful in the GFC selloff, less so in the long small cap drawdown from 1994 through 2001.

In table 5 we present results for just the –30 to –40% drawdown range, by country and sector (monthly data). The smallest median future 1 year returns were recorded by Telecommunication Services, Utilities, Taiwan, China and Malaysia. The largest median future 1 year returns were recorded by Consumer Discretionary, Consumer Staples, Financials, South Korea, Philippines, India and Singapore.

Again, these monthly results highlight simply buying the market after a 30-40% fall was not historically a riskless strategy, but they do provide some support for gradual accumulation at such levels.

Concluding remarks

This brief note measures market return performance over the 1, 2 and 3 years after Asian stocks fall by given threshold levels. It provides a simple assessment of, historically, when should an investor begin accumulating stocks during a market selloff, given actual prediction of a market bottom is essentially impossible.

Results highlight the relationship between the magnitude of selloff and subsequent returns. Generally speaking, the greater the selloff, the greater the future return. It is also evident that when a selloff reaches –30% or lower the balance of risks begins to shift towards favoring a gradual accumulation strategy, even though the market may fall significantly further.

Written by: Dr. Hamish Macalister