April 28, 2016

What You Should Remember About the Markets

Because I have been an investment professional for more than 40 years, I sometimes get asked my opinion about the markets. These questions usually come from those without  a systematic approach toward investing. Here are some typical questions and answers:

Question: How much do you think the stock market can drop?
Response: 89%
Question: What?!!
Response: Well, that is the most it has dropped in the past. But past performance is no assurance of future success, so I guess it could go down more than that.

Question: I just looked at my account, and it is down. What should I do?
Response: Stop looking at your account.

Question: What are you doing now?
Response: What I always do … following my models.

After these responses, I am usually not asked any more questions.

Simple But Not Easy

Some say investing is simple, but not easy. This is due to myopic loss aversion, which combines loss aversion, where we regret losses almost twice as much as we appreciate gains, with the tendency to look at our investments too frequently.

We should remember that we cannot control the returns that the markets give us, but we can control what risks we are willing to accept. If we do not have systematic investment rules, it is easy to succumb to our emotions that cause us to buy and sell at inappropriate times. The annual Dalbar studies show that investors generally make terrible timing decisions.

But investing does not have to be difficult if we have firm rules in place to keep us in tune with market forces. A sailor cannot control the wind, but she can determine how to take advantage of it to get her where she wants to go.

I have found the most important principle to keep in mind is the old adage “the trend is your friend.” As some say, "the easiest way to ride a horse is in the direction it is headed." To remind me of how important it is to stay in tune with the long-term trend of the markets, I have this on my office wall:

Source: Quotatium.com

Trend Following

Many are familiar with this saying, but few have the ability to always adhere to it. Much of Warren Buffett’s success is because he had the vision to stick with his approach over the long run no matter how the markets treated him. Buffett once said, “You don’t have to be smarter than the rest. You have to be more disciplined than the rest.” This discipline applies not only to staying with existing positions. It also means re-entering the market when your approach calls for it, even though uncertainties may still exist.

What gives me the ability to stay with the long-term trend of the market? First is knowing how well trend following has performed in the past. Let us now look at that, as well as how I determine the trend of the market.

Absolute Momentum

There are different approaches to trend following, such as moving averages, charting patterns, or various technical indicators. The trend following method I prefer is absolute (time-series) momentum. It has some  advantages over other forms of trend following. First, it is easy to understand and to back test. It looks at whether or not the market has gone up or down over your look back period.

In my research going back to 1927, absolute momentum had 30% fewer trades than comparable moving average signals. From 1971 through 2015, our Global Equities Momentum (GEM) dual momentum model had 10 absolute momentum trades that exited the stock market and had to reenter within a 3 month period. A 10-month moving average had 20 such exits and reentries. The popular 200-day moving average had even more signals. Fewer trades mean lower frictional costs and fewer whipsaw losses. 

You do not need to enter and exit right at market tops and bottoms to do well. In fact, if your investment approach is overly sensitive to price change and tries to enter and exit too close to tops and bottoms, you will often get whipsawed.

Because of whipsaw losses and lagging entry signals, trend following often underperforms buy-and-hold during bull markets. This is the price you pay for protection from severe bear market risk exposure.

But since absolute momentum has a low number of whipsaw losses, the relative momentum part of dual momentum can put us ahead in bull markets over the long run. Absolute momentum can then do its job by keeping us largely out of harm’s way during bear markets. The tables below show how absolute momentum, relative momentum, and dual momentum (GEM) have performed during bull and bear markets since 1971. Dual momentum has outperformed in bull markets while converting bear market losses into crises alpha profits.

Bull and Bear Market Performance January 1971 - December 2015 

Bull Markets
S&P 500
Abs Mom
GEM
Jan 71-Dec 72
36.0
32.6
65.6
Oct 74-Nov 80
198.3
91.6
103.3
Aug 82-Aug 87
279.7
246.3
569.2
Dec 87-Aug 00
816.6
728.4
730.5
Oct 02-Oct 07
108.3
72.4
181.6
Mar 09-Jul15
227.7
136.8
106.4
Average
277.7
218.1
292.7
Bear Markets
S&P 500
Rel Mom
GEM
Jan 73-Sep 74
-42.6
-35.6
15.1
Dec 80-Jul 82
-16.5
-16.9
16.0
Sep 87-Nov 87
-29.6
-15.1
-15.1
Sep 00-Sep 02
-44.7
-43.4
14.9
Nov 07-Feb 09
-50.9
-54.6
-13.1
Average
-36.9
-33.1
3.6
Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Please see our Disclaimer page for more information.

Robustness

My research paper, “Absolute Momentum: A Simple Rule-Based Strategy and Trend Following Overlay” showed the effectiveness of absolute momentum across eight different markets from 1974 through 2012. Moskowitz et al (2011) demonstrated the efficacy of absolute momentum from 1965 through 2011 when applied to equity index, currency, commodity, and bond futures. In “215 Years of Global Asset Momentum: 1800-2014,” Geczy & Samonov (2015) showed that both relative and absolute momentum outperformed buy-and-hold from 1801 up to the present time when applied to stocks, stock indices, sectors, bonds, currencies, and commodities.

Greyserman & Kaminski (2014) performed the longest ever study of trend-following. Using trend following momentum from 1695 through 2013, they found that stock indices had higher returns and higher Sharpe ratios than a buy-and-hold approach. The chance of large drawdowns was also small compared to buy-and-hold.  The authors found similar results in 84 bond, currency, and commodity markets all the way back to the year 1223! Talk about confidence building. These kinds of results are what give me the ability to stay with absolute momentum under all market conditions.

Market Overreaction 

I have some clients though who are less familiar with and sanguine about trend following. They still get nervous during times of market stress, such as August of last year. They need to also understand that stocks do not trend all the time. The stock market can overextend itself and mean revert over the short run. During such times it is important for investors to stay the course and not overreact to short term volatility.

To remind me to remind others about short-term mean reversion, I have this coffee mug in my office:

Source: Quotatium.com

This tells me to ignore market noise and calmly accept occasional market overreactions that are usually followed by mean reversion. There is no way to get rid of short-term volatility and still earn high returns from our investments. We should, in fact, embrace short-term volatility since it is what leads to superior returns over the long run.

What to Remember

Rigorous academic research confirms the existence of trend persistence and short term mean reversion. Whatever your investment approach, if you respect these two forces you should be able to invest with comfort and conviction. Being aware of these principles gives us the two qualities required for long run investment success. First is the discipline we need to follow your proven methods unwaveringly.

The second is patience.


Warren Buffett said the stock market is a mechanism for transferring wealth from the impatient to the patient. Like Buffett, we also need to patiently accept inevitable periods of short-term volatility and underperformance with respect to our benchmarks.

If you have trouble always remembering the concepts of trend persistence and mean reversion, then do what I do. Get yourself a poster and coffee mug.