How to react to the next Lehman Shock?

Wednesday, 22 May 2019
Written by Prof. Yasuyuki Kato

Last September marked the 10-year anniversary of the Lehman shock (September 2008). In general, shocks are events that have a major impact on the economy and the market, such as rapid stock price declines and commodity prices. In the Lehman shock, the global market share price (MSCI-ACWI * 1) plunged by nearly 50%.

Since we have reached the 10-year anniversary, we have seen media comments along the lines of "Is the current stock market in a bubble?". On October 10th 2018, the US Dow Index (30 shares of the Dow Jones Industrial Index) fell by about $ 832 per day, making this debate even more interesting. Certainly, until mid-2018, US stocks continued to hit record highs. Japanese stocks have also risen since Abenomics, and have recorded the highest price since the bursting of the bubble in the 80's. As corporate performance is strong, it appears that stock prices have risen accordingly.

On the other hand, the outlook for the global economy looks uncertain given factors such as the rejection of globalism by President Trump, the US-China trade war, the rise of populism in Europe, global financial deterioration, and changes in monetary policy in many countries. The significant market drops in the 4th quarter of last year also seem to reflect these fears. There may be many who are worried that the second Lehman shock may be coming.

I think that the recent debate on whether the stock market is in a bubble is very difficult to determine until the bubble bursts. In other words, it is impossible to predict shocks. However, it is not a waste of time to think about how to deal with a shock like the Lehman shock. It is the same as practicing evacuation routes for when a large earthquake occurs. When shocks occur, it is normal for most people to be upset and unable to make rational decisions. In this blog, let's think about how long-term investors should respond when a catastrophe such as a Lehman shock occurs.

Before considering the response method, it is first necessary to understand certain characteristics of the stock market. It is a characteristic called "mean reversion". Although market prices fluctuate, they tend to return to average values. In other words, if it goes up, it goes back down and if it goes down, it goes back up. Of course, stock prices will rise in the long run, but will rise and fall along the way. If the stock has a true value, it means that the stock price will oscillate. In particular, in the case of a major shock such as the Lehman shock, the market tends to overreact, and the decline is greater than necessary.

However, it is common for the subsequent rise to be large. Given this property, the response to a shock is clear. That means buying more shares if you have enough money. In other words, shock is a great opportunity to buy more stocks.

Therefore, let's have a look at four hypothetical investors in the case of the Lehman shock as an example, and simulate and check what action should be taken in the case of shock.

Let’s assume that each of Mr. A, Mr. B, Mr. C and Mr. D held ¥ 400,000 of cash and ¥ 600,000 of global stock (total ¥ 1 million) just before the Lehman shock (at the end of August 2008). Global shares are represented by the MSCI-ACWI index * 1. The allocation ratio is 40% cash and 60% global stocks. Also. the Lehman shock occurred in September 2008 and the global stock price (MSCI-ACWI) dropped 36% from the end of August at the end of October so the global equity asset value fell from 600,000 yen to 384,000 yen (In order to make the calculations easier let’s round this to 400,000 yen). It is assumed that the assets of four people are similarly reduced to 800,000 yen with cash of 400,000 yen and stock of 400,000 yen, and four people take different actions at that point.
• Mr. A: Sells all shares and holds cash only (cash is 800,000 yen)
• Mr. B: Does nothing, leaves cash at 400,000 yen, stock at 400,000 yen
• Mr. C: Buys shares with some of the cash (80,000 yen) leaving cash of 320,000 yen and stock of 480,000 yen
• Mr. D: Buys shares with all of the cash held (¥ 400,000) leaving a portfolio 100% stock (¥ 800,000)

Let's examine the performance of these four people for the next year (end of October 2008-end of October 2009). Transaction costs are not included and we ignore interest earned on cash. The change in the amount of assets of the four people is as shown in the chart below.

Stock prices continued to decline after October 2008 but rose after that. From the end of October 2008 to the end of October 2009, the rate of increase in the amount of assets for each person was as follows: no change for A, 6.8% increase in B, 8.2% increase in C, 13.6% increase for D.

In other words, the amount of assets increased as people bought more shares. On the other hand, Mr. A, who thought he was safe and switch everything to case, ended up with the smallest asset amount. This was an example of a Lehman shock, but the other shocks that have occurred so far have similar trends, albeit with differences in timing. In other words, "mean reversion" has occurred. For long-term investors, a shock means that it is a good time to invest in stocks.

By the way, Mr. C's action (purchasing stock for 80,000 yen in cash) is actually the same as normal rebalancing. Rebalancing means returning the asset allocation ratio that has been shifted due to stock price fluctuations to what was initially determined. The original asset allocation of the four was cash ¥ 400,000 and stock ¥ 600,000. The shock changed the distribution to ¥ 400,000 in cash, ¥ 400,000 in shares, i.e. 50% in cash, 50% in shares. Therefore, all Mr. C did by transferring a portion of cash (80,000 yen) to stock was to return it to the original allocation ratio with cash 320,000 yen, stock 480,000 yen (i.e. allocation ratio is 40% cash, 60% stock).

As for Mr. D, putting all the cash in stock and making a bold bet is one way, but there is also the possibility that the downturn will continue. In fact, Mr. D's assets continued to fall sharply after the shock. The investment behavior of Mr. C's rebalance is an excellent way to make use of mean reversion while keeping the level of risk at an acceptable level. By the way, this rebalance is included in the investment policy of major institutional investors such as pension funds. It can be said that successful pension funds have been rebalancing in spite of major shocks.

Even if a shock occurs, rebalancing as usual is usually the best way to respond to the shock. This rebalancing is also conducted regularly at MYTHEO, and asset allocation is maintained at the target ratio.

In addition, if we continue the simulation until five years after the shock (Figure 2), three people – B, C and D who appeared in the previous example have seen their assets recover to above 1 million yen i.e. above the level held before the shock. Needless to say, it can be said that it is a wise choice for investors to keep investing for the long term without being unduly influenced by short-term trends.

Article By Prof. Yasuyuki Kato
Professor at Kyoto University Graduate School. Masters degree from Tokyo Institute of Technology, PhD from Kyoto University. Previously Executive Director at Nomura Securities Co., Ltd. Director of the Financial Engineering Research Center at Kyoto University. His specialty is investment theory and financial engineering. Academic adviser to Money Design Co., Limited.

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