Three Scenarios and Expected Returns
The Real Economy
I have been trying to solve the puzzle based on three scenarios: a V shaped recovery, U shaped and L shaped economic trajectory.
In the real economy, a V shape recovery appears a write off. economies worldwide have started to shut down in 2Q 2020. The lockdown may extend into 3Q. By then you either test the entire population or develop a vaccine. The first option appears more plausible. As long as a few asypmtomatic people are spreading the disease, we will quickly have a problem.
Assuming the western countries like the US open their economy too early, there will be repeated infection waves. Therefore 3Q could see more defaults by SMEs. Job losses could reach 20% in many countries.
Emerging countries may decide not to lock down their economies because it causes a recession and the governments need to provide handouts. These countries have sovereign and corporate debt issued in USD to enjoy a lower interest rate. But if the money printing leads to currency instability, it may be a repeat of 1997 - 98's Asian Crisis. This crisis should play out in 2021 / 22. Therefore emerging markets equities may remain subdued for the next 1 to 2 years.
There are reports that mention that survivors do not build immunity. If they get re-infected, it will be very damaging. A vaccine may not work. In this scenario, it will be a "U" shaped economy.
The Stock Markets (Wall Street)
It appears to be a "V" shaped recovery. This is no doubt fuelled by liquidity and fiscal stimulus by central banks worldwide. I've heard from SME business owners in the US, borrowing money and receiving grants, using it to buy stocks because there is no demand.
I prescribe a 25% probability for a V shaped recovery. In a V shaped recovery, S&P500 recovers by 24% within 6 months and zero returns from 6 to 12 months. It means if you missed the boat, that's it. It will be sideways from Oct 2020 to Apr 21.
For a "W" shaped, meaning a double bottom but the second bottom not exceeding the first, then in the next six months, we should see an 18% drop. Thereafter from six to 12 months, a 48% recovery in S&P500. It pays to wait around six months or buy slowly over the next six months as markets fall.
For a much-feared "L" shape, habits change, vaccines don't work. The recession could last for two to three years. People travel much less, spend much less, repeated lockdowns, massive defaults, policy mis steps and social unrest. I prescribe a 25% probability.
The S&P500 will fall 50% in the next six months, and recover back to today's level at 2750. There should be a 100% from the bottom from six to 12 months.
Using expected returns, a combination of 3 scenarios produces a potential 15.5% negative return in the next six months. But from six to 12 months a whopping 49% return. Hence I shall be very cautious in the next six months, conserving cash, investing slowly. I will hold half my portfolio in cash and the other half either hedging or buying quality funds and shares.
I have been trying to solve the puzzle based on three scenarios: a V shaped recovery, U shaped and L shaped economic trajectory.
In the real economy, a V shape recovery appears a write off. economies worldwide have started to shut down in 2Q 2020. The lockdown may extend into 3Q. By then you either test the entire population or develop a vaccine. The first option appears more plausible. As long as a few asypmtomatic people are spreading the disease, we will quickly have a problem.
Assuming the western countries like the US open their economy too early, there will be repeated infection waves. Therefore 3Q could see more defaults by SMEs. Job losses could reach 20% in many countries.
Emerging countries may decide not to lock down their economies because it causes a recession and the governments need to provide handouts. These countries have sovereign and corporate debt issued in USD to enjoy a lower interest rate. But if the money printing leads to currency instability, it may be a repeat of 1997 - 98's Asian Crisis. This crisis should play out in 2021 / 22. Therefore emerging markets equities may remain subdued for the next 1 to 2 years.
There are reports that mention that survivors do not build immunity. If they get re-infected, it will be very damaging. A vaccine may not work. In this scenario, it will be a "U" shaped economy.
The Stock Markets (Wall Street)
It appears to be a "V" shaped recovery. This is no doubt fuelled by liquidity and fiscal stimulus by central banks worldwide. I've heard from SME business owners in the US, borrowing money and receiving grants, using it to buy stocks because there is no demand.
I prescribe a 25% probability for a V shaped recovery. In a V shaped recovery, S&P500 recovers by 24% within 6 months and zero returns from 6 to 12 months. It means if you missed the boat, that's it. It will be sideways from Oct 2020 to Apr 21.
For a "W" shaped, meaning a double bottom but the second bottom not exceeding the first, then in the next six months, we should see an 18% drop. Thereafter from six to 12 months, a 48% recovery in S&P500. It pays to wait around six months or buy slowly over the next six months as markets fall.
For a much-feared "L" shape, habits change, vaccines don't work. The recession could last for two to three years. People travel much less, spend much less, repeated lockdowns, massive defaults, policy mis steps and social unrest. I prescribe a 25% probability.
The S&P500 will fall 50% in the next six months, and recover back to today's level at 2750. There should be a 100% from the bottom from six to 12 months.
Using expected returns, a combination of 3 scenarios produces a potential 15.5% negative return in the next six months. But from six to 12 months a whopping 49% return. Hence I shall be very cautious in the next six months, conserving cash, investing slowly. I will hold half my portfolio in cash and the other half either hedging or buying quality funds and shares.
| V shaped recovery | |||||||
| Probability | Return by Apr 21 | Expected return | Trajectory | 6mths | 6 - 12mths | ||
| 25% | 24% | 6.00% | 24% | 0% | |||
| W shaped recovery | |||||||
| 50% | 36% | 18.00% | -18% | 48% | |||
| L shaped recover | |||||||
| 25% | -20% | -5.00% | -50% | 100% | |||
| 19.00% | -15.50% | 49.0% |
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