Market conditions suddenly changed in February after a strong start in 2018. This new development is not surprising considering equities made these new all-time highs on thin volume. This prompts us to ask ourselves: Is this the beginning of a bear market or a bump down the road? Only time will tell…
However, we clearly see that we are in the late expansion stage of the business cycle. This stage is often characterized as an overheating of the economy and this is exactly what’s happening in the US. Many key data such as employment are coming stronger than expected, something seen when growth peaks.
Right now, the US economy is running above its potential and causing an inflationary gap. As the spectre of inflation is looming and becoming more real, the Federal Reserve has an incentive to adopt an even more hawkish stance, in other words to aggressively pursue rate hikes as an attempt to curb inflation.
There is usually a time-lag before any rate hikes have a perceptible impact on the economy. It is estimated interest rate changes take up to 18 months to have a full effect. In the meantime, when rates rise, an asset rotation takes places from equities to bonds and this sometimes triggers a risk-off effect.
With that being said, let’s review how the Inovestor StockPointer Canadian Equity Strategy behaved when equities tanked and infer what could happen with the Horizons Inovestor Canadian Equity ETF (INOC) in a downturn. Please see below the rolling maximum drawdown since inception.
The rolling maximum drawdown is defined as the maximum loss in percentage from a peak to a trough of a portfolio, before a new peak is attained. It is a common indicator of downside risk over a specified time. In nine years of track record, the strategy never posted larger drawdowns than the S&P/TSX TR.
The next chart shows the value added over the benchmark is generated when markets are falling. The defensive nature of the EVA-centric StockPointer strategy in Canada is explained by its SPscore ranking system. Cyclical companies tend to score poorly and they are a huge part of the S&P/TSX.
Also, Canadian cyclical companies such as the ones in the energy sector are usually very high beta stocks. Having a minimal exposition to these two sectors allows the portfolio to lose less when markets are falling. However, the main drawback is lagging the S&P TSX when it is rising significantly.
As a reminder, the strategy is drift weighted while the ETF is equal weighted. We believe equal weighted is a better weighting scheme when markets are falling as it provides a better diversification and reduces the specific risk of the portfolio. For this reason, we expect the ETF to fare better in a downturn.