Analyzing the Crisis Fund: Maximizing Profits During Market Panics
Making money in a bear market.
“The time to buy is when there’s blood in the streets.”
— Baron Rothschild
Fortune Favors the Prepared Mind
Our friends over at Quantbase, the world’s first SEC-registered high-risk roboadvisor, created something they’ve dubbed the Crisis Fund.
Here’s how they describe it:
A fund that invests into an allocation of stocks that do well in crises, based on factors back tested to 1974. The fund detects a bear market using the high yield spread — when the difference between junk bond and US Treasury interest rates is above 6.5%.
Let’s dissect that statement together…
Understanding the Actual Stocks
This is a fund that invests in stocks that apparently do well in times of crisis. They select these stocks by running them through a set of specific characteristics.
The Seven Characteristics the Fund Considers
Positive net income (profitable)
Actively deleveraging (paying off debt)
Low trading volume (low volatility)
Free cash flow positive (putting money in the bank)
High net-debt to EV ratio (usually old, big, dividend-paying companies)
Considered a value stock (low price-to-earnings ratio / undervalued)
High asset turnover (more revenue per invested dollar into the business)
Think about it — in times of economic turmoil, I definitely want to be investing in companies with the above characteristics. They’re profitable, paying off debt, putting cash in the bank, likely big, old, and paying a dividend, and undervalued.
It sounds like a dream company.
So when does the fund begin investing in these type of companies?
Understanding the Determination of Being in a Crisis
The fund determines if we’re actually in a crisis by calculating the difference in interest rate between junk bonds and the US Treasury. If this difference is above 6.5%, then we’re ruled to be in a crisis.
High Bond Yields are to Incentivize Investors
Think about it like this — companies often issue corporate bonds to raise money. This money can be used for nearly anything. Investors, like you and I, buy these bonds expecting a return.
Companies like Apple and Microsoft are very stable and liquid companies, so as an investor I would feel confident in buying their bonds knowing they’ll pay me back my money + interest in the future. These type of investment-grade bonds will pay anywhere between 2-4% on your money (interest rate).
However, as the markets and economy worsen, companies who really need money (they’re usually unable to convince a bank to lend to them at a reasonable interest rate) will begin issuing corporate bonds at very high interest rates — think 8% or higher. They issue bonds at these high rates to try and convince investors to buy in and give them their money — they’re desperate.
This figure historically runs closer to 5-6%, which means when it peaks to 8%, 10%, or even 12% — companies are becoming more and more desperate to borrow money in efforts to run their business.
Companies usually aren’t desperate like this when the economy is booming and the markets are rocking & rolling.
This 6.5% spread is back-tested and seen as the best indicator of a crisis.
In summary, this fund invests in companies (determined by a set of characteristics) who perform best when the high-yield spread is above 6.5% (which only happens during economic turmoil).
How Exactly Does it Work?
When the high-yield spread is below 6.5%, the fund is 100% invested in the S&P 500 — ensuring your normal market returns. However, when the high-yield spread hits 6.5% and climbs higher, the fund begins shifting into stocks that meet the seven characteristics described above.
Remember, when a crisis starts the high-yield spread isn’t automatically 6.5% — it creeps its way up there as a snowball effect of junk bonds are issued to the public markets.
This could take several months — sometimes more.
The stock market is a leading indicator, which means while the high-yield spread is increasing due to more and more junk bonds being offered — the stock market is likely beginning to trade down as the investors panic.
By the time the high-yield spread hits 6.5%, the S&P 500 has likely already corrected by some -15% or -20% before it flips the switch. However, the individual companies it’s switching into (as we’re all well aware) are likely trading much lower than -15%.
I would argue Facebook is a company that might fit these seven characteristics. Despite the S&P 500 being down -20% YTD, Facebook is down -52%. This is a wonderful example where the fund would pivot out of allocation in “the market” and into oversold, profitable, free cash flowing value stocks.
The fund’s goal is not to time the market top. Instead, the fund’s goal is to ride with the market until we’ve likely begun to experience a “bottom,” then pile into profitable, oversold, and undervalued companies — then ride their gains all the way back up as the economy recovers.
Then, once the economy has made it’s recovery we begin to see fewer and fewer high-interest junk bonds being offered — lowering the high-yield spread back below 6.5%, causing the fund to shift back into the S&P 500.
If you’re interested in learning more about the research that goes into this, here’s a link to the original 77-page study published a few years back.
If you want to read Quantbase’s description of the strategy, I’ve linked it below.
Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.