MARKET DROP RETURNS EQUITY TO NORMAL SHARPE RATIO
-- A PUBLIC SOURCED ARTICLE FOR MATASII READERS REFERENCE - 10-12-18 - ""Eye-Watering" Equity Drop Returning Market To "Normal", Nomura Says" --
This was not supposed to happen - everything is running so well, unemployment, 'soft' survey data, sentiment, Trump comments, the economy... so why the massive double top? And it must be a buying opportunity, right?
However, while this carnage comes as a shock to market participants used to low-vol-high-return environments under the central planning of global central banks, as Nomura's Bilal Hafeez notes, this is actually returning stocks to the old "normal" - so get used to it...
While US stocks are now up a paltry 2% (before the US open) so far this year, on a 12-month basis they are up around 7%, which almost exactly the average return since 1960.
Now if we subtract by cash yields to arrive at excess returns and then adjust by volatility, we get to the Sharpe ratio. We find the current 12m Sharpe ratio to be 0.35 , which is similar to the historic average (see chart below, I exclude dividends).
Last year was shocking
So even though the recent drop in US equities has been eye-watering, the reality is that we are reverting back to historical averages. Instead, it was always the super-smooth ascent of US equities last year that was shocking. That ascent saw 12m returns reach over 20% by early January this year and the Sharpe ratio reaching a whopping 3.5 (see chart below). That’s a return Warren Buffett would be proud of, but anyone long an S&P500 ETF would have achieved. But with the recent drop, we can now see what separates Buffett from the rest of us.
Previous surges, see lower subsequent returns
The last time we saw a similarly high peak Sharpe ratio of 3.5 or higher was all the way back in late 1995. After that peak, returns fell, and volatility rose. The good news was that the Sharpe ratio stayed positive for a while. Over the subsequent 1y after the peak, the Sharpe ratio averaged 1.9, and the subsequent 3 years after the peak, it averaged 1.5 (see chart below).
That was of course the dot-com boom phase.
1960s also saw negative years after surges
Outside of that episode, we have to go back to the 1960s to see similarly high Sharpe ratios of 3.5 or higher being achieved. The most obvious difference to the 1995 phase was the large swings seen in the Sharpe ratio from positive to negative over that decade. Indeed, we saw the worst loss in Sharpe ratio terms in that period. Naturally the subsequent 1y and 3y averages after the peaks were also much lower than what we saw after the 1995 peak.
The bottom line is that we need to re-centre our US stock return expectations – low vol/high returns like 2017 are unlikely to be seen again. US stocks normally only beat cash by 3%-5% and volatility is higher. And if the 1960s are anything to go by then negative years soon follow high peaks.