Wednesday, September 14, 2016

How to Make Momentum Investing Work

Momentum investing is the idea of buying stocks that are strong and not buying (or shorting) stocks that are weak.  Like it's almost opposite cousin, value investing (buying stocks that are undervalued and not buying stocks that are overvalued), momentum investing shows extremely strong long term returns, but also goes through long periods of underperformance.  In a new paper "Two Centuries of Price Return Momentum" by Chris Geczy and Mikhail Samonov, the authors look at momentum going back into the 1800's and find significant periods of time when momentum investing is painful. 

If momentum investing works so well over the long term, why doesn't everyone do it?  The answer is what Cliff Asness refers to as time dilation.  An academic can do research on momentum and find strong long term returns and what look like insignificant period of underperformance or bad performance and not be worried at all.  In the real world, even a short period where something is not working can create tremendous pressure to sell out or change course.  So while momentum is an exploitable market anomaly, in the real world one cannot put all their eggs in the momentum basket.

The key to making momentum "work" is to combine a momentum stock strategy with other types of strategies that have different risk/return characteristics.  Some examples might be intermarket analysis, value investing, or even momentum with volatility filters to limit drawdowns.

Momentum investing is a very powerful anomaly that investors should exploit.  However, historically momentum has had a number of periods or underperformance or bad performance, to mitigate this it should be combined with other, non correlated, methodologies. 

Wednesday, August 3, 2016

Does Long Term Mean Reversion Still Work?

I  just read an article in Institutional Investor about the problems that Grantham, Mayo, Van Otterloo & Co (GMO) are having with their long-term mean reversion strategy:

GMOs Mean Reversion Strategy Is Testing In Today's Markets

Mean reversion works by trying to find times when certain markets are overextended to the upside or the downside. A mean reversion strategy would avoid markets that are overextended to the upside and buy markets that are overextended to the downside. They work because markets are constantly forming bubbles that subsequently burst. While this sounds intriguing, there is a problem. Bubbles can go for a long time before they burst so mean reversion strategies can be on the wrong side of things for a while until they ultimately pay off. 

If individual and institutional investors truly had long-term time horizons, then this wouldn't be a problem, but in real life the hardest thing for any investor to do is watch other people make money while they are not. It appears the stock market is in a bubble [PO1] and possibly has been for a while. However, it keeps going up and any corrections are short lived. At some point it will probably crash, but that could be years away. And that’s GMO’s big problem. GMO’s long-term strategies do not align with their clients’ shorter-term realities.

Is there a Better Mean-Reversion Approach?

Markets have always reverted to their mean, but since mean reversion can take a long time, a better approach could be to align the mean-reversion time frame to the investor’s time frame. That approach could create a better investor experience. Investors might talk about how they have a long time horizon, but when markets are moving against them all of that goes out the window. Mean-reversion strategies can be moved to monthly, weekly, daily, even intraday time frames. Instead of trying to only catch the major market turning points (i.e. bull and bear markets), these types of strategies can look for much shorter-term turning points, from intermediate-term corrections all the way down to intraday reversals. Unlike long-term approaches that would rely on valuation, which wouldn't work for shorter-term models, these approaches could use intermarket analysis, cyclic analysis, or traditional overbought/oversold indicators. 

Intermarket Analysis 

Intermarket analysis involves taking two or more markets that are related to each other and looking for divergences. For example, lets assume stocks and Treasuries move inversely and that bond traders tend to be quicker at predicting turning points than stock traders. An intermarket model could then look to buy stocks when they are going down while Treasuries are moving down at the same time. The model would sell stocks when they are moving up and Treasuries are moving up at the same time. 

Cyclic Analysis

Cyclic analysis would take some measure of market cycles and look to buy into short-term weakness and sell into short-term strength.

Traditional Overbought/Oversold Indicators

Traditional indicators like RSI can also help determine short-term overbought/oversold areas. Traditional RSI measures looked at 14 periods, but there has been some good work by Larry Connors and others looking at shorter-term measures.

Markets are mean reverting by their nature, so any well-thought-out mean-reversion strategy can be successful. Longer-term models are problematic, however, as they don't line up well with investors true time frames. Shorter-term models can still capture the longer-term moves while also lining up better with what investors want. At the end of the day it’s about meeting investors’ comfort zones and expectations. Sometimes traditional approaches do not align with these needs. Since central banks are dominating capital markets, this is one of those times.


Wednesday, June 29, 2016

Global Markets Going Nowhere

Thanks to Sarhan Capital for pointing this out, off the lows of the other day here is how far some markets are off their highs and the levels they are trading at:

The S&P was down 6.7% from highs and was trading where it was in Sept 2014.
The Dow...down 7.5% and Sept 2014.
Nasdaq...down 12.6% and Sept 2014.
Nasdaq 100...down 11.8% and Nov 2014.
Transports...down 24.5% and Nov 2013.
Russell 2000...down 16.2% and Oct 2013.
NYSE...down 11.9% and July kidding.
XLF (Financial SPDR)...down 43% and trading where it was in 1999. Yes...financials and yes 1999! 
How about foreign markets?
German Dax...down 25.6% and Jan 2014.
FTSE...down 18.7% and March 98...again...not kidding. We were surprised about this.
Shanghai...down a whopping 54%...and Feb 07.
Nikkei...down an unreal 61.8%/all time high in 1989 at 38,957. How's that money printing working for you?
Hang Seng...38.5% and Jan 07

Wednesday, May 11, 2016

Changing the Structure of Tactical Return Generation

Tactical equity strategies that seek to outperform the market will typically try to accomplish this goal by limiting downside capture during bear markets.   By their nature, tactical strategies don't expect to get 100% upside capture during a bull market (unless they are using a decent amount of leverage) so the only way to outperform the market is through limiting downside capture.  If this can be done consistently then the tactical strategy won't outperform the market on a year by year basis, but it should outperform handily over a full market cycle. 

Since by their nature tactical strategies will have significant periods when they are out of the market, they will miss some upside.  The tradeoff is that they should also miss a lot of downside and a lot of volatility.   If the investor can take a long term view , instead of comparing the tactical strategy to the market every month, quarter, or year then they will experience very attractive returns vs. conventional investment strategies.  However, this is often easier said than done as bull markets are much more prevalent than bear markets and it is hard for investors to ignore the noise without making comparisons to the market.  Traditional tactical strategies are much better than modern portfolio theory and buy and hold but not quite optimal from an investors standpoint.

To be truly tactical a strategy must have times when it is out of the market or underinvested in the market.  These will usually be times of great risk, however during some of these times the market will still rally.  Since most tactical strategies take an intermediate to longer term view of markets, the times they are out or underinvested can be over a month, a quarter, or even a year.  The longer they are out of the market or underinvested the greater chance of missing out on upside capture.  A solution to this issue is to shrink time frames from rebalancing monthly or weekly, to rebalancing daily or even intraday.  So instead of being out of the market or underinvested for a month or longer, a strategy using daily and intraday time frames might be out for a day.  So instead of losing upside capture for a month, quarter, or year, such a strategy would lose upside capture for a day.  This can completely change the definition of a market cycle, instead of having to wait years to outperform the market the market cycle can be compressed into a month.  Instead of corrections lasting weeks, a correction in this case is a down day.  Instead of bear markets lasting a year or more, a bear market in this case could last a week.  Compressing the time frames in this manner allows the tactical strategy to outperform the market on a monthly basis and creates return streams that are much more palatable to ordinary investors.

Monday, May 9, 2016

What World War Z Can Teach Us About Investing

In the movie World War Z a virus starts turning people into Zombies and they threaten to take over the world.  The main character, played by Brad Pitt, is tasked with finding out what happened and how to cure it.  On this mission he hears that Israel was the only country not overrun by the zombies because they built a massive wall before the outbreak.  When he travels to Israel to find out how they predicted what was going to happen they tell him about the 10th man doctrine.  This is a committee of 9 people and a 10th man.  If all 9 people agree on something, it is the 10th man's responsibility to disagree, not matter how far fetched his findings might be, and prepare for that eventuality.   When the Israelis first heard word of zombies all 9 people agreed that it was nothing, the 10th man then had to disagree and build a wall just in case there was a zombie apocalypse. 

What does this have to do with investing?  Everything.  In investing the path of least resistance is to conform to what everyone else is thinking, that way if you are wrong everybody else is wrong at the same time.  It is also easier to believe the most recent past will equal the future.  So if we are in a bull market the consensus is that the bull market will continue, if we are in a bear market then the consensus is that the bear market will continue.  The 10th man doctrine would force you to look beyond the consensus at other possible scenarios and prepare for them. 

Since we have been in a bull market for 7 years one likely scenario is that it will keep going.  If you listen to CNBC that is probably the consensus, so you must be prepared for it.  However, what if it doesn't keep going?  Other likely scenarios are a bear market or the market we have seen since August, with large corrections followed by large rallies without really going anywhere, continuing.  Since you can't predict markets your portfolio has to be prepared for either of these eventualities as well. 

Friday, March 25, 2016

The Current Market Environment and Implications for Tactical Asset Allocation Part III

As I write this the market has gone through what looks like another V shaped correction.  After a few of these types of moves in succession we can no longer call it a fluke, it may not be the new normal but we have to expect that these types of moves will be more common in the future.  Buy and hold and asset allocation don't handle these types of moves well.  They experience all the downside and then ride the market back up, ultimately not going anywhere but having a wild roller coaster ride with all of the emotional minefields that causes.   Asset allocation strategies also have asset classes that move down more than US stocks, magnifying losses.  Traditional tactical strategies don't offer much of a solution to these types of environments.  They can lower the losses on the downside, and if a correction turns into a bear market they come out like heroes.  But, if the correction quickly reverses tactical strategies will take a while to get back in and experience the gains.  These types of strategies look to latch onto trends that last weeks or months, but in this new environment trends are now lasting hours to a couple of days.  By the time a traditional tactical strategy reacts the trend has already changed.  

Investing in the market involves risk and reward.  A good investment strategy has the proper balance between the two---the less risk and more reward the better.  To improve an investment strategy you can increase reward while keeping risk constant, lower risk while keeping reward constant, or any combination that increases the ratio.  Buy and hold and asset allocation will always have a terrible risk reward ratio, there are large potential rewards but the risk is huge.  Traditional tactical strategies have much better risk/reward ratios but if this choppy market environment persists and we don't see a bear market soon it will be difficult for investors to see that.  Similar to this concept is the idea that every investment strategy has its Achilles Heal, the market environment that it just won't perform well in.  Another key then to improving an investment strategy is to make its Achilles Heal as insignificant as possible.  This is impossible in buy and hold and asset allocation as these types of strategies will always ride a market down, reducing the Achilles Heal would involve turning these into tactical strategies.  Traditional tactical will not perform well in choppy markets, this is not significant if markets are trending most of the time, but in this environment all we have seen are choppy markets for two years, making the Achilles Heal much more significant.  The key to improving tactical strategies is in reducing this Achilles Heal and making it much less significant.  The key to this is understanding that time frames have changed and tactical strategies have to be even more responsive to market shifts than ever before.

In the past, running a tactical strategy could be simple, you could just apply a 200 day moving average to the S&P 500 on a monthly basis and rotate in and out at the end of the month.  You would never get out at the top or in at the bottom but trend changes gave enough warning that you didn't need to.  Today, trend changes can happen in an instant, giving no warning at all.  There is still a place for looking at multi month momentum but it can no longer be the centerpiece of an investment strategy.  Markets are too choppy month to month.  There is one place however where momentum still exists, that is intraday.  In this new environment, what happens day to day is much more important than ever, the market can go up or down massive amounts in the space of a couple of days and the shift can happen intraday.   The key to improving the performance of a tactical strategy in choppy markets then is to combine strategies that have much shorter holding periods, from a couple of hours to a couple of days, with traditional longer term strategies.  These strategies can take advantage of the momentum that is still present during a trading day or overnight, without experiencing the gut wrenching ups and downs of a longer term approach.  A market that ultimately goes nowhere has enough of these short term movements that a tactical strategy using short term strategies can make money regardless of how choppy the market is.  Applied appropriately these types of strategies can shift the Achilles Heal of a tactical strategy from a choppy market that lasts over a couple of weeks or months to a choppy market that lasts for a day.  So instead of having problems navigating a market that can move up or down 10% or more over a couple of weeks, which is easy to navigate using short term strategies, the problem shifts to choppy markets intraday that might move up and down 1-2%.  This makes the Achilles Heal of a tactical strategy much smaller while at the same time reducing risk and increasing potential returns. 

Tuesday, March 8, 2016

An Example of Forward Looking Due Diligence in System Development

When most investors do due diligence they look at past returns and expect them to persist into the future.  Unfortunately, they rarely do.  Forward looking due diligence takes past returns with a grain of salt, the goal is to determine where the returns came from and how likely they are to persist.  Forward looking due diligence can be done on money managers, investment strategies, and tactical methodologies.

We recently developed a model for the SPDR S&P 500 ETF (SPY).  The model can either be long SPY, short SPY, or in cash.  From 3/7/2011 to 3/7/2016 it makes $142.6 on one share of SPY, not including any dividends.  For comparison to buy and hold SPY opened at $132.86 on March 7, 2011 and closed at $200.59 on March 7, 2016, so buy and hold would have only made $67.73.  So far so good, our strategy  more than doubles buy and hold over this period.  If we look at the annual returns of our strategy it would have also made money ever year with a low of $3.75 in 2014 and a high of $55.28 in 2015.  Still so far so good.  However, over the past 12 months the strategy made $81.14 and it made $28.24 in February, $14.18 in December, and $14.66 in September.  Those are the best, third best, and fourth best months for the strategy over 5 years, and they all happened within the last 12 months.  On the one hand this tells me that the strategy will do its best in a troubled market.  One the other hand I am worried about whether returns like this can persist.

Backward looking due diligence would place a lot of money into this strategy expecting these recent returns to persist.  In fact our optimization program wants to allocate 50% or more to this model.  Forward looking due diligence is much more cautious.  Yes the strategy has done exceptionally lately, and yes we are likely to stay in a market environment that is conducive to this strategy.  However, the strategy has done so well that the returns actually border on ridiculous, they could persist but they could also revert back to the mean.  Looking at the monthly returns the strategy is up 6 months in a row (March is currently down).  It has only done that once before.  This could be the best model we have ever developed but we have decided to limit exposure to 12.5% until we have a bad month or any type of drawdown.