Market Timing and Risk Management, Part 2 – Momentum

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…

Continue reading “Market Timing and Risk Management, Part 2 – Momentum”


Market Timing and Risk Management, Part 1 – Macroeconomics

Last week’s post ended with a bit of a cliff-hanger: I wrote about how the major stock market disasters are highly correlated with U.S. recessions. Since it doesn’t look like we’re anywhere close to a recession let’s not get too worried about the stock market volatility in early February! But I didn’t really elaborate on why I’m not that concerned about the U.S. economy right now. So, today’s post is about what indicators would I look at to reach that conclusion.

The broader context of this post and, hopefully, a few more followup posts in the coming weeks is the question that I’ve been grappling with for a while:

What would it take for me to reduce my equity weight?

You see, a lot of my safe withdrawal rate simulations assume either constant equity weights (e.g. 80/20) or a rising equity glidepath in early retirement (see the SWR series Part 19 and Part 20). But what would entice me to do the opposite? Throw in the towel and reduce my equity share as a Risk Control! Should I ever even consider that?

The broad consensus in the FIRE community seems to be to stoically keep your asset allocation through thick and thin. Physician on FIRE had a brilliant post, adequately titled “Don’t just do something. Stand there!” on why not to react to market swings. That was in 2016 and I very much agreed with that assessment back then. But that doesn’t have to be a universal truth. In my wedding vows, I swore to stay with my wife through “good times and bad.” But the last time I checked I’m not “married” to my equity portfolio, so I should have the right to at least consider scenarios that would convince me to pull the plug on stocks.

If nothing else, thinking about when would be a good time to dump stocks gives me the confidence not to lose my nerves when those conditions are clearly not present, such as during the volatility spike earlier this month. So, what would be the indicators I’m following? Today, Part 1 deals with the macroeconomic picture (but in a future post, I will also share my thoughts on momentum/trend-following etc. as requested by some readers). Among all the different macroeconomic indicators, here are my three favorites… Continue reading “Market Timing and Risk Management, Part 1 – Macroeconomics”

Joined at the hip: The Macroeconomy and the Stock Market

This is a topic I wanted to cover for quite a while and I think this is the perfect time for it: I got a few posts lined up already dealing with the intersection of macroeconomics and (personal) finance. Of course, I can already hear one objection:

“Oh, come on Big ERN, did you see the volatility in the stock market last week? My portfolio went down by 10+% since the January 26 peak and you want to talk about macroeconomics now? The first week of February 2018 proves that the macroeconomy doesn’t matter for stocks!”

And my response: Yes, this is actually the perfect time to talk about macroeconomics! See, the main reason I was not overly concerned about the market volatility earlier this month is that the economy seems to be running just fine and there don’t seem to be strong signs of any impending recession. Of course, the stock market has some wild swings, sometimes during a recession, sometimes outside of a recession. But all the really bad disasters, the bear markets that sunk retirement dreams in my Safe Withdrawal Rate historical simulations, they all occurred during recessions. And not just any minor garden-variety recession but the big ones! In other words, this is how I insist macroeconomics matters for the stock market:

What do we make of a 10% drop in the stock market? It’s a buying opportunity during an economic expansion! But during a recession, the market might potentially get a lot worse before it gets better!

And in today’s post, I like to provide some empirical evidence for my view…

Continue reading “Joined at the hip: The Macroeconomy and the Stock Market”

U.S. Equity Returns: History and Big ERN’s 10-Year Forecast

Expensive equities are a hot topic these days. Jack Bogle warned of lower expected equity returns recently (only 4% nominal!) and the CAPE has finally crossed 30 this month, according to Prof. Shiller. What does that mean for investors? What does it mean for early retirees? There has been a flurry of activity in the FIRE blogging world on this topic with posts by Physician on FIRE, JL Collins, Think Save Retire, and two consecutive ChooseFI Monday podcasts with JL Collins and with yours truly just two days ago discussing this topic, too.

I don’t think anyone has recommended selling equities and running for the hills. I certainly haven’t, and I am probably one of the more pessimistic FIRE bloggers. Please don’t buy gold coins! Personally, I would never bet against the U.S. stock market. If you had invested $1.00 in large-cap equities in 1871, your investment would have grown to over $13,000 by July 2017, even adjusting for inflation. In nominal terms, to more than $260,000! How amazing is that?

S&P500 Cumulative Returns
Real, CPI-adjusted S&P500 returns. $1.00 would have grown into over $13,000! (for full disclosure, the index didn’t exist back then and has been back-filled with historical stock return data by some smart economic historians)

So the good news is: Stocks have the tendency to go up, on average. The broad index not just recovered from every possible disaster we have ever encountered (2 world wars, the Great Depression, several financial crises, the Dot Com bust, 9/11, etc.) but rallied to reach one all-time high after the other. After every cycle of fear, we see a quick recovery back to economic fundamentals. But buried in the equity return chart above is one small piece of bad news; the flipside of the market bouncing back from disasters and returning to the trend is that stocks also underperform after long periods of above-average performance. And this is where Jack Bogle is coming from. He doesn’t forecast a new bear market – nobody can – but simply predicts a decade of underwhelming returns after the strong bull market over the last 8 years. How do you even make a forecast like that? That’s the topic for today’s post…

Continue reading “U.S. Equity Returns: History and Big ERN’s 10-Year Forecast”