In volatile markets you must be able to go to cash when markets become dangerous. That is exactly what the momentum selection model does well. It protects your capital on the downside and enables it to grow on the upside! If you insist on staying in the stock market at all times, even perfect foresight cannot protect you. The ability and willingness to periodically run away beats the macho strategy of holding on.
So writes Monty Pelerin (www.economicnoise.com) in edited excerpts from his original article* entitled Stay in Markets – Part III.
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Pelerin goes on to say in further edited excerpts:
The final part of this series [read Part I here and Part II here] discusses a momentum investing strategy and applies it to the downturn of 2008. Its results are compared with that of the buy-hold outcome.
The Momentum Approach
A momentum approach identifies which sectors or markets are performing well and then moves funds into these areas. This approach can be used with industries, sectors, within sectors (i.e., best performing stock(s) within a sector), ETFs, mutual funds etc. [Read: Momentum Investing: Ride the Market Waves to Big Profits]
For purpose of illustration, the simple two-asset world of EFA and SPY will be continued. Doing so allows a comparison with the buy and hold results achieved in Part II.
The momentum approach uses multiple performance measures, including measures of rates of change and volatility, to rank assets. For selection purposes, high recent returns rank high while high recent volatility ranks low. Additionally, other minimum criteria are used to screen out assets that do not exceed an acceptable minimum threshold, regardless of the performance rankings.
The minimum threshold criteria mean that a portfolio may not be fully invested at all times. If not enough ETFs exceed the minimums, then cash replaces…them in the portfolio. Thus, for any given time period, a portfolio may be fully invested, partially invested or all cash. Market conditions and asset choices dictate.
To account for cash, a third ETF is used as a cash proxy. SHY, a short-term bond ETF, is used in what follows. Cash itself or some other relatively risk-free, short-term bond fund would yield comparable results.
The Mechanics of Momentum Investing
Momentum investing requires regular updating of the performance measures. These measures are used to select the assets to be included in the portfolio. The time period for re-balancing is judgmental and situational. Commonly used re-balancing choices are bimonthly, monthly and quarterly. In some cases weekly or annually are appropriate.
This model uses monthly re-balancing. The reason for such a short re-balancing period is based upon the volatility and danger inherent in current markets. If you are “trading in front of Armageddon,” you cannot afford to overstay your welcome.
The monthly re-balance was a reasonable compromise between other alternatives. Quarterly re-balancing was deemed not frequent enough and bi-monthly did not add meaningful value while doubling the calculations and potential transactions.
The Results of Momentum Investing for January 2007 through March 26, 2013
Using the momentum algorithm, one ETF was selected at the beginning of each month and held for a month. One hundred percent of equity was put into that one asset. The selection process was repeated each month thereafter and the portfolio adjusted each month based rankings. In some cases the same ETF ranked highest for several consecutive months.
Each month either SPY, EFA or SHY was selected. SHY was only selected when neither SPY or EFA met minimum acceptance criteria.
The beginning $10,000 equity grew to $18, 143 under the momentum method. This compares favorably with the performance of SPY ($12,576), EFA ($9,626) and a 50-50 weighted portfolio ($11,101) over the full period. For the six-plus years, the total return from momentum investing was 81.4%, dramatically outperforming the buy and hold strategies.
Graphically, the equity balances of all four portfolios are shown over time:
Take-Aways From The Chart
The superior outcomes exhibited by the momentum strategy are obvious. Less obvious, are the following observations:
- The momentum strategy never went negative. That is, throughout the period equity never went below $10,000.
- All of the buy-hold strategies saw equity nearly halved from its beginning amount. Around the 26 month mark the value of buy and hold strategies declined to around $5,000.
- Around month 19, the buy and hold strategies plummeted while the momentum portfolio actually grew slightly.
- The maximum drawdown of SPY and EFA were 55.2 and 61.0% respectively. Drawdown represents the largest drop in total equity in percentage terms. For buy and hold strategies, the largest drop occurred during the market selloff in 2008 (approximately months 12 through 28).
- The maximum drawdown of the momentum strategy was 16.4%. Interestingly, the maximum drawdown occurred around months 40 to 47 (around the first quarter and second quarters of 2010) and not during the major market sell-off of 2008.
The following table provides the detail by month.
DETAILS BY MONTH
|End Date||Portfolio||Return||SPY||EFA||Best of 2|
The table above consists of monthly data. It includes, reading from left to right, the selection made by the momentum algorithm, the return on that selection, the return of SPY, EFA and then the better return of SPY and EFA.
Some points worth noting from the detail:
1. Any time SHY was chosen, the portfolio was out of the stock market and into cash (cash equivalent). Some serious monthly losses were avoided by going to cash. SHY avoided at least a monthly loss of 2.3% in July of 2007. In the downturn of 2008, SHY was a regular selection. Note the massive losses that were avoided in September, October and November of 2008.
2. The column to the right needs some commentary. It represents the best return for that month between SHY and EFA. It was created to show what “perfect foresight” might produce. It required you to invest in stocks but allowed you to always select the better performing of the two choices. In some cases, “better” was “less bad.” Although such knowledge is unavailable in real investing, it provides an interesting benchmark to see the value of periodically leaving the stock market. This column grew equity to $23,205, higher than that of the momentum selections. While that should not surprise, the following point might.
3. The graph below adds the “perfect foresight” equity line to the graph of the other lines.
The two red arrows point to important conclusions. Even with “perfect” foresight, the equity line went negative. A drawdown from about $11,000 to about $6,500 occurred in 2008. The other red arrow shows that it took almost four years before the mythical “perfect’ foresight model overtook the momentum selection model. The important point is in volatile markets you must be able to go to cash when markets become dangerous. If you insist on staying in the stock market at all times, even perfect foresight cannot protect you. Without perfect foresight, your pain will be even greater. This last point cannot be emphasized enough in the markets we faced thus far this century.
If you expect…[the markets to remain volatile] as I do, then you must ensure that you have some objective means of leaving the scene…before tragedy strikes. That is exactly what the momentum selection model does well. It protects your capital on the downside and enables it to grow on the upside!
To put this into perspective, a breakdown of the time spent in each asset is useful. The portfolio was all cash 29% of the time. It was invested in SPY 47% and EFA 24% of the time. On average, the portfolio was in cash about 3.5 months per year.
The ability and willingness to periodically run away beats the macho strategy of holding on.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
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