With the S&P 500
and other broad U.S. market averages at or near all-time highs, now is the time for investors to work with their financial advisers on strategies for reducing bear-market losses. It likely will be too late if you wait until a crisis hits.
Fortunately, investors have a (relatively) new tool for predicting which stocks are most likely to lose the most in the next bear market.
That’s good news because, for most of the past 50 years, investors had just one tool in their arsenal for predicting which stocks were most susceptible to a market downturn. I’m referring to beta, which measures a stock’s sensitivity to changes in the overall market. Stocks below a beta of 1.0 tend to be less volatile than the market itself, while stocks with betas above 1.0 tend to be more volatile.
The notion of beta emerged decades ago from the Capital Asset Pricing Model, and since then has been endlessly studied and analyzed. It is of unquestionable value. But it does have its limitations during a liquidity crisis. Consider the limited protection beta alone provided investors in the bear market during the 2007-09 financial crisis. As you can see from the accompanying chart, low-beta stocks lost nearly as much as high-beta stocks during that period.
The new tool to which I’m referring is based on the insight that, during severe financial crises, stocks are vulnerable not just to a downturn in the broad market but also to the loss of liquidity. I’m referring to how easy or difficult it is to sell a stock without affecting its price. During a crisis, it will be easier to sell a liquid stock than an illiquid one without causing its price to decline. And the more illiquid ones will fall the most.
This new tool is referred to as a stock’s “liquidity beta,” to differentiate it from the “market beta” that goes by the abbreviated name “beta.” It was introduced in academic circles almost 20 years ago by finance professors Lubos Pastor at the University of Chicago and Robert Stambaugh of the Wharton School of the University of Pennsylvania.
In a new study that the National Bureau of Economic Research recently began circulating, the professors updated their research by analyzing whether their original conclusions have held up in the real world since then. Out-of-sample results are the gold standard in statistical research, of course, since they provide strong confirmation that the original results weren’t just a random fluke.
Pastor and Stambaugh report that the evidence supporting their liquidity beta over the last two decades is even stronger than before.
Keep in mind that, if history is any guide, you will pay a price for investing in stocks with the lowest liquidity betas. Though they should lose much less during the market’s next liquidity crunch, they should gain less when liquidity is plentiful. That’s because stocks with high liquidity betas — those most sensitive to the loss of liquidity — must perform so much better during non-crisis periods to compensate investors for the risk of losing big when a crisis does hit.
In fact, according to professors Pastor and Stambaugh, the average high-liquidity-beta stock performs well enough during non-crisis periods to withstand its huge losses during a liquidity crisis and still come out ahead of the broad market over the long haul. Investors will be attracted to such stocks when their prevailing mood is at the greed-end of the fear-greed spectrum, just as they will be drawn to low liquidity-beta stocks after a liquidity crisis hits the market and fear becomes the dominant emotion.
By then it will likely be too late to shift your portfolio to such stocks. To quote the famous words of Doug Kass, president of Seabreeze Partners: “Risk happens fast.” Therefore, with the U.S. stock market at or near an all-time high, now is an ideal time to start compiling a list of attractive stocks with the lowest liquidity betas.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com