Take Action Before the Next Pandemic

In a post COVID-19 investment world, optimists and pragmatists will naturally embrace the can-do ethos of German philosopher Friedrich Nietzsche: “that which doesn’t kill us makes us stronger.”

The COVID-Crash qualifies a “black swan” event, defined as being rare, unpredictable, and beyond the realm of normal expectations. The market’s fall from its high on February 19th to bear market territory was the fastest on record. It was about 3x faster than 1929, 4x faster than 1987 and 6x faster than 1990 – the prior record holders. 

The only thing even close within our lifetimes was the 1987 Black Monday crash. Both events are characterized by extremely sharp drops during a bull market. Just as the novel COVID-19 virus caught healthcare professionals without therapeutics or vaccines, it also caught investors and algorithms unprepared for the crash.

The good news: We now have its DNA and fingerprints.

While an ordinary bear market is characterized by a lethargic roll-off that picks up steam towards a v-bottom, a black swan crash is characterized by an extremely sharp drop to oversold conditions during a bull market. Its unusual characteristics in volatility, downside volume, and a flight of capital from equities to treasuries makes early detection possible. What’s more, mean reversion during rebound provides further investment opportunity.

When a Black Swan’s fingerprints are detected, a comprehensive tactical response must include both “mitigation” and “vaccination.” Vaccination algorithms seek to detect the onset of a Black Swan event via its unusual characteristics and promptly trade risky equities for comparatively safe US Treasuries. Mitigation employs inverse-momentum algorithms during the following rebound when mean reversion is expected to favor the sectors and asset classes most punished during the crash.

SwanGuard Vaccination seeks to detect the onset of Black Swan events via spiking volatility early enough to signal a move from at-risk equities to comparatively safe US treasuries.  Unfortunately, before developing the SwanGuard Vaccination algorithm we first had to see an example of a Black Swan event’s character. SwanGuard Vaccination was finally completed and deployed on July 22nd 2020 -- thus the charted improvement (green) shown for a broad market portfolio (red) during the first few months of 2020 is hypothetical.

SwanGuard is now an integrated extension StormGuard, and has been deployed across our SectorSurfer, AlphaDroid, and Merlyn.AI offerings. There is no further action required to enable SwanGuard in the future. Indexes with inception dates before July 22nd 2020 will not show the effects of SwanGuard before this date as their history is locked. Indexes with later inception dates will show hypothetical backtesting utilizing all algorithmic features available as of its inception date.

Practical Notes:
All published MAI Indexes employ the TLH iShares 10-20 Year Treasury Bond ETF when SwanGuard is triggered. The treasury ETF emoployed by other AlphaDroid and SectorSurfer models may will depend on the fund options specified by its Bear Market Strategy. The algorithm will select the first treasury ETF it identifies within its candidate fund list. If none is identified, TLH will be selected by default. If your brokerage account does not permit you to select TLH, you may optionally (1) select an alternative treasury ETF that is available to you or (2) simply go to the safety of a money market fund.  

While this pandemic too shall pass, many questions remain about how we as individuals, advisors, and a society will react to the next virus. Will we trust the models? Will the media scare us? Will the government shut down the economy again? Is this the new normal? Perhaps most important is the question of whether we will do anything different. There is no guarantee that we will be luckier or smarter next time. But we do know that there will be a next time. And we know that we’d better be prepared with a plan when the next Black Swan pays a visit.