• Klaus Meitinger

Reality check: Seismograph passes litmus test.

Kapitalmarkt Seismograf 1Dear Readers,

For more than two years now, we have been regularly informing you about developments on the capital market seismograph. Our aim is to help you better assess opportunities and risks on the stock market. At the same time, we use it to derive short-term changes in the equity ratio in the private wealth stock market indicator.

In 2019, this had worked brilliantly (see News from the Editor, 17.01.2020: Seismograph impresses in 2019). 2020 was now the ultimate litmus test for the model. Dramatic crash, V-shaped recovery, then bull market as prices climbed a wall of fear - investors could have gone very wrong over the past twelve months. Did the investment approach based on the capital market seismograph also add real value in 2020? A review.

The story of the capital market seismograph began more than ten years ago at the Technical University of Munich. Professor Rudi Zagst, together with a panel of academics and renowned practitioners including Dr. Oliver Schlick, the former Managing Director and Chief Investment Officer of Bayerninvest, had developed a model to forecast crisis probabilities - the capital market seismograph. This distinguishes between three market states: If the seismograph signals "green", this means that a calm market with a positive trend is expected. Investors can invest with peace of mind. "Yellow" indicates a turbulent market with positive expectations. And "red" indicates a turbulent market with negative expectation. The advice is then: do not invest.

Later, Schlick, together with Zagst, expanded the model into an investment approach that provides clear recommendations regarding stock weightings in the respective market environment. Since 2018, private wealth has published these results regularly. The editors link four expectations with this: First, the seismograph is intended to provide timely warning of turbulence and thus limit losses in a downtrend. Second, the approach should correct the defensive bias without much delay once the storm clouds have cleared, allowing investors to participate in the upward phases of the stock markets. Thirdly, it is intended to avoid the frequently made mistake of reacting too often in sideways phases with strong fluctuations. For it is rightly true that back and forth makes pockets empty. And fourthly, the investment result should be better on balance in the long term than with a pure buy-and-hold strategy.

Could the approach meet these expectations in 2020?

January 2020: The sky over the capital market is cloudless. The probability of rising share prices is over 90 percent. The investment approach has therefore been recommending "full investment" for weeks now and has participated in the year's initial rally on the stock markets. The DAX is quoted at 13450 points. It seems to be a good investment year.

February 2020: The German stock barometer marks an all-time high at around 13,790 points. The seismograph is in full swing. Towards the end of the month, however, fears of the new type of Corona virus are spreading. However, this still seems to be a phenomenon limited to China. Nevertheless, the fear of a collapse of the Chinese economy is pushing the DAX down by around 1000 points. In the case of the seismograph, the probability of negative turbulence is beginning to rise slightly. However, the model remains fully invested.

Early March 2020: The situation comes to a head. The development of infections outside China and fears of a global pandemic cost the DAX another 1000 points in the first week of March. The probability of negative turbulence in the model increases further - but not enough to justify a reduction in the equity allocation at around 11,500 points in the DAX. Then things move very quickly. The probability of negative turbulence ("red") increases quickly and dramatically. A massive storm is looming. The investment approach recommends reducing the equity weighting to zero.

In panic mode, the market falls to just above 8000 points by the second half of March. The speed of the crash is breathtaking. The market loses in just four weeks roughly what it had lost in 15 months during the financial crisis. Given this speed, even the seismograph only reacts after the first downward wave. But at least it can limit the loss of a pure equity portfolio to just over 20 percent compared with the start of the year. "That might have saved some sleepless nights. We have to remember: At the time, there was pure panic - and no one knew how much further share prices would fall," comments Oliver Schlick

Surprisingly, the market then quickly turned around. In view of the support measures provided by monetary and fiscal policy, which were unprecedented in terms of volume and speed, the DAX had already climbed back up to around 10,000 points by the end of March. "The crucial question now was: would the model increase the equity ratio again?" says Schlick.

April 2020: The recovery on the stock markets continues. And the seismograph does indeed react quickly. As early as the beginning of April, the model starts to gradually increase the equity quota. At the beginning of May, the approach again recommends an exposure of 100 percent. In mixed portfolios, that's a significant overweight. "This has actually worked out very well. In April, hardly anyone had dared to invest again. The fact that the model signalled at that moment that the storm was clearing and that a high equity weighting was now once again justifiable was extremely pleasing," recalls Oliver Schlick.

What were the reasons for the turnaround? "Three things," explains the professional: "First, volatility fell very sharply in April. Second, interest rates have normalized. During the crisis, their structure had signaled a high level of fear in the market. That changed in early April. And third, short-term interest rates fell massively as central banks pumped a lot of money into the system. So the overall probability of negative turbulence went down dramatically, the storm was over according to our indicators."

May 2020: the DAX gets a strong push from the middle of the month and trades back above 12500 points in the first week of June. "Hardly anyone who got out in panic mode in March benefited from this move. Most investors were convinced at the time that the bear market had two stages - as so often in the past. They therefore waited in vain for a second setback before buying," explains Schlick.

July to September 2020: the market now continues to trend upwards on balance - but with two significant setbacks in July and September. "However, the indicators changed only very slightly during this phase and did not suggest any renewed negative turbulence," says Schlick

October/November 2020: a second wave of infection threatens, economic indicators point downwards again. The stock markets lose around ten percent. A correction? Or the beginning of another crash? "Many investors have reduced their stock holdings again during this movement. What is interesting is that nothing significant had happened in the indicators of the model during this period. LIBOR remained consistently low. Volatility stopped increasing significantly. The data simply did not behave the way it did at the beginning of a crisis. That's why the full investment recommendation remained unchanged," Schlick recalls.

When news of a working vaccine broke on 9.11, share prices jumped by 5-10 percent within minutes. Those who had previously reduced their equity exposure now had to chase the prices. The approach was invested and benefited from the vaccine boost.

December 2020: The DAX ends the turbulent year 2020 at around 13700 points. A mixed portfolio of 50 percent DAX and 50 percent cash - without any change in allocation - would have returned just under three percent last year. How well did the seismograph perform against its targets in this environment?

"The exit signal in March came after the first market setbacks , but not too late," says Schlick, "at least equity investors weren't in danger of losing house and home in a completely uncertain disaster situation." In fact, the loss was limited to about 20 percent, and the subsequent crash of more than 20 percent was avoided. And if the financial world had actually gone under in the spring of 2020 - no one could rule that out at the time - investors would not have been affected.

Then, when the markets quickly recovered and the storm clouds cleared, the model responded very well. In a world of fear, it was extremely quick to recommend full investment again and has maintained this despite interim turbulence. In the volatile sideways phase in the second half of the year, it thus also fulfilled objective number three perfectly. "All in all, I'm very happy with it," Schlick concludes.

What about performance? "If an investor had changed the equity allocation between zero and 100 per cent over the course of the year in line with the seismograph's signals, his total return would have been around 3.75 per cent. Although the model slid into the March crash fully invested, it ultimately performed better than a mixed portfolio of 50 percent DAX and 50 percent cash, which would have yielded just under three percent. That is very positive", Oliver Schlick informs.

How does the seismograph go into the New Year?

In the first days of January, the seismograph continues to show the picture that has been familiar for weeks. The probabilities for a calm, positive stock market (green) and a turbulent positive stock market (yellow) add up to well over 90 percent. Negative turbulence is unlikely. "The recommendation remains: Significantly overweight equities," Schlick says.

Bottom line for investors:

We use the results of the capital market seismograph for short-term positioning within the corridor suggested by private-wealth stock market indicator. Since the Ifo economic indicator is positive, but the valuation on the stock markets is now very ambitious, this corridor is between 60 and 90 percent of the capital earmarked for equity investments. Because the seismograph suggests that an overweighting is advisable, an offensive orientation is still indicated. On balance, therefore, the equity allocation of the private-wealth stock market indicator remains at 80 percent.

One point should be noted, however: The only thing currently standing in the way of an even higher equity allocation is the valuation of the markets. The underlying calculation of the fair value of the DAX is based on data material since 1954 and assumes, among other things, a medium-term return of real interest rates to long-term averages. As you can see from the coverage of the Lerbach Round in the current magazine, however, this assumption can certainly be called into question with a view to the next decade. Without this assumption, a significantly higher equity weighting would be appropriate. Over the next two weeks, we will therefore calculate what "zero interest forever" would mean for the equity weighting in the model.

We wish you a successful investment year 2021,


Klaus Meitinger

Note: Despite careful selection of sources, no liability can be accepted for the accuracy of the content. The information provided in private wealth is for informational purposes and is not an invitation to buy or sell securities.

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