I started a new series in February on Market Timing Risk Management (part 1 was on macroeconomics) but never got beyond the first part. So, finally, here’s the second installment! Part 2 is about momentum (sometimes called trend-following) and this is a topic requested by many readers in the comments section and via email. Specifically, many readers had read Meb Faber’s working paper on this topic, which by the way is the Number 1 most popular paper on SSRN with 200,000+ downloads. I always responded that read that paper and found it quite intriguing but never followed up with any detailed explanations for why I like this approach. Hence, today’s blog post!
And just for the record, I should repeat what I’ve said before in the first part: I have not suddenly become an equity day-trader. I am (mostly) a passive investor who likes to buy and hold equities. But with my early retirement around the corner and my research on Safe Withdrawal Rates and the menace of “Sequence Risk,” I have that nagging question on my mind: Are the instances where an investor would be better off throwing in the towel and selling equities to hedge against Sequence Risk? At the very least, I’d like to have some rules and necessary conditions that need to be satisfied before I would even consider reducing my equity exposure. I think of this as insurance against overreacting to short-term market volatility!
So, without further ado, here’s my take on the momentum signal…
Using momentum as a way to tactically time the equity allocation (as well as many other assets classes) is not rocket science! There are many different versions of this rule and one of the simplest, yet still very effective, version is the one favored by Meb Faber: Every month-end, calculate the average of the last ten monthly S&P500 closing values (including the current one) and compare the current level to the 10-month average.
- If the current index level is above the 10-month moving average, then you want to be invested in equities.
- If the current index level is below the 10-month moving average, then you want to be out of the equity market.
It’s really that simple. Why ten months? Well, the research shows that any time horizon between, say, 5 and 12 months seems to work, but the “sweet spot” is around 10 months. It’s a short enough horizon that you’ll still capture the major turning points in the stock market in a timely fashion, but long enough to not overreact to every little blip in the market. Though even with this rule there have been a lot of false alarms, more on that later!
Let’s look at a simple example, see below. For the calendar month of October 2007, the S&P500 closed at 1549.38. The average closing S&P500 levels over the nine preceding months plus October itself was 1482.77. Since the October close was above that average we’d keep our equity exposure:
Forward one month and the index dropped to 1481.14, which is below the 10-month rolling average. That’s a sell signal!
Talking about 2007, the 10M-momentum signal would have been amazing at timing the exit from the equity market in 2007. You’d have missed the equity market peak by only one month and avoided the whole mess during the global financial crisis. The buy signal would have come in May 2009, only about three months after the market bottom. An investor following this rule would have avoided a 34% drop in the (total return) index!
But, for full disclosure, the momentum signal also creates a lot of false signals! For short-term market fluctuations, this signal sucks! Here’s one example from 2015. You’d have sold after a temporary drop in August 2015 but then the market rallies again and you’ll buy back equities at a higher price! We’ll see below that there were quite a few such false alarms!
Let’s look at what happens when we apply this simple momentum rule to my historical equity returns. One thing I still have to specify is where we’d invest the money we pull out of the stock market. Apparently, Meb Faber assumes you invest in a low-risk short duration investment like cash (e.g. 3-month or 1-year T-bill). I will look at two different options:
- longer-duration Treasury bond, i.e., 10-year bonds.
- cash, e.g., short-term T-bills, similar to a money market account (and similar to Meb Faber’s calculations).
In the chart below is the cumulative growth of $1 invested in January 1871. And yes, this already inflation-adjusted! Because of the tremendous equity return potential, we have to plot this using on a log-scale on the y-axis!
- With the S&P500 (with dividends reinvested), $1 would have grown to over $14,400 by 2017!
- With the momentum strategy, replacing stocks with 10-year bonds while the sell signal was in effect, $1 would have grown to over $190,600 by 2017!
- Almost equally impressive, shifting to cash (i.e., short-term T-bills) during the sell signals would have grown the $1 investment to over $116,000 by 2017!
How about some more detailed stats, ERN-style? Here are the (real, inflation-adjusted) return stats for the three asset classes stocks, bonds, and cash as well as the two alternative momentum strategies. (Note: return and risk are calculated on an annualized basis, returns are compound returns). I also calculate the return/risk ratio and the maximum drawdown percentages. Some noteworthy results:
- The momentum strategies yield higher average returns with lower risk and lower drawdowns! You almost double the return per unit of risk!
- The Stock->Bond signal gives you slightly better outcomes, especially when looking at the latter part of the sample. Thanks in part to the strong bond bull market since 1982!
- Both bonds and cash had some nasty drawdown percentages during the 1970s and 1980s! That’s because I calculate the returns as real returns. In nominal terms, of course, a money market account would never have any drawdown!
Some more info on the drawdowns. Again, with the drawdown I measure how far the total cumulative return drops below the all-time-high prior to that point. Keeping an eye on drawdowns is particularly important for retirees because of Sequence of Return Risk (see part 14 and 15 in the SWR series!). Remember, you can have a great average return throughout your retirement but if the drawdown early on in your retirement is too deep and/or too long you’ll still run out of money. In any case, the drawdowns would have been greatly reduced with the momentum signals as we can see from the plot below. Especially during the last two bear markets 2001-2003 and 2007-2009, when the momentum strategies barely lost more than 15% from the peak!
A closer look at the 64 sell and buy signals since 1926
Let’s get a better sense of when the momentum signal works and when it doesn’t. Remember, the way the signal is constructed, your returns will be identical to the passive equity strategy if the momentum signal is bullish on stocks (i.e., the S&P500 is above its 10-month rolling average). Differences in returns come about only during the times when you sell equities and temporarily hold bonds or cash. There were 64 such instances since 1926 (I look at the shorter subsample to save space) with varying durations. In the right two columns, I calculate by how much the respective momentum signals would have out/under-performed the S&P500. Out of 64 sell signals, I counted only 25 that “worked,” when buying bonds and only 17 when shifting to cash. Those are pretty measly hit ratios of 40% and 27%, respectively. The reason the momentum signal was so successful in the overall stats is that during the failures, the momentum strategy underperformed by “only” single digits (with a few exceptions, mostly during the Great Depression), but when it works it sometimes hits the ball out of the park! 170% during the Great Depression, two back-to-back 30+% in the early 2000s and 66% during the Global Financial Crisis!
Let’s sort the sell signals by how much excess return they would have added over an equity buy-and-hold signal. I also add two more columns: how many of the months between the sell and buy signal occurred during a recession (as defined by the NBER) as well as what percentage of the months out of the market that occurred during a recession. Notice a pattern? Most of the great success stories of the momentum signal occur during a recession and most of the false alarms occur during economic expansions! That makes sense, because as I have written in a post before: macroeconomics and the stock market are joint at the hip: The equity drawdowns around recessions are those that are deep enough and long enough to be correctly timed with this momentum signal! And the false positives normally occur during economic expansions when the stock market mean-reverts too rapidly for the 10-month momentum signal to properly pick up what’s going on!
Why a momentum strategy works: the stock market is no Random Walk
None of this momentum business would ever work in real life if the stock market followed a true Random Walk (with upward drift, of course) in the strict mathematical sense. Past returns would be completely uncorrelated with and independent of future returns and thus irrelevant for predicting future returns! But as I mentioned in a post from a few months ago, the stock market isn’t exactly a random walk. And again, to calm down the critics and the trolls, I’m not saying that the stock market is perfectly predictable. I am merely saying that it tends to occasionally overreact on both the upside (dot-com bubble) and downside (Global Financial Crisis). The transition path between these cycles of greed and fear seems to be gradual and slow enough for a momentum signal to work!
How about taxes and transaction costs?
Personally, if I ever wanted to implement this strategy for timing my equity exposure, I’d probably avoid selling large quantities of stocks in taxable accounts. The tax benefit of deferring capital gains and paying the IRS only once when you actually need the money probably outweighs the timing benefits of the momentum signal. But within tax-advantaged accounts (IRAs, Roth IRAs, 401ks, etc.) where I can easily move money without tax consequences and without transaction costs (just swap one mutual fund for another) I will definitely consider this momentum signal!
The past performance of this momentum strategy has been quite amazing. You lower the drawdowns and risk while increasing average returns at the same time. But this momentum signal isn’t fool-proof either. There are many false alarms! During short-lived equity pullbacks, you are almost guaranteed to sell stocks close to the market bottom, only to buy them back at a higher level during the following recovery. But in the historical simulations, the numerous small “failures” of the momentum signal were offset by several large home runs when you could have avoided the big equity drawdowns!
So, even though I am still a passive buy-and-hold investor at heart, I think it would be a mistake to ignore this signal. At the very least, I’d add this momentum signal to the three macroeconomic signals I outlined in the first part of this series (yield curve, unemployment claims, ISM index)! Actually, monitoring both macroeconomic and equity-market-based signals might even be the solution to avoiding some of the false alarms that the momentum signal inevitably generates. Recall that most of the false alarms occur during economic expansions and most of the successful sell signals occurred around NBER recessions!