We recommend that you use 5-7 outcomes. The HiddenLevers default scenarios are:

  • S&P Valuation: 21 PE - Typical Recession
  • S&P Valuation: 33 PE - Late 90s Average
  • Baseline: S&P Up 20%
  • Baseline: S&P Down 20%
  • Past Crashes: Financial Crisis 9/1/08 - 3/9/09
  • S&P Valuation: 27 PE - Flatline
  • Baseline: Treasury rates up 100bp

HiddenLever defaults are set with the following methodology:

1. Historically, major market events (with equity downside > 20%) occur roughly twice a decade (this is the experience seen over the last 120 years of US market history). As a result, the Primary Scenario is set to occur 82% of the time by default (slightly more than 4 out of 5 years being "normal" years).

2. Once we get into the roughly 18% of the time that we see bigger market movements, the HiddenLevers research team had to make some decisions on what scenarios to use as a reasonable set of risks:

We want to ensure that a range of risks is taken into account - not just recessionary risk, but also black swan (eg. financial crisis) risk and surprise rate shocks. Since S&P valuations provide a very broad-based way to look at equity risk, we use this scenario to look at a range of valuation outcomes. Outside of the financial crisis probability, which was deliberately set based on the historical frequency of major financial disruptions, the other scenarios are equally weighted in order to take an even-handed approach to forward-looking forecasting - as no one can accurately predict the future.

3. In terms of judging the appropriateness of this scenario set as a set of defaults, we periodically review the impact of the model on broad-based ETFs and funds, take SPY and AGG as two examples.

SPY currently shows up as -46% risk / +56% reward (5yr return) using the HL default scenario set. This provides an appropriate potential downside, while also exhibiting upside in line with long term S&P total return.

AGG currently show up as -6% risk / +8% reward (5yr return) using the HL default scenario set. The max drawdown for AGG over the past decade is 5%, and its total return over the past 5 years is in the mid-teens - although bond valuations are currently stretched just like equities.

We are planning to add a feature to HiddenLevers which makes it easier to select your own probabilities and see how this impacts major asset classes so that you can more easily tune the model to fit your own capital markets assumptions.

Updated August 20th, 2019.