First let me state a few disclaimers, just in case anyone bothers to read this post.
I am a firm believer in quantitative analysis and scientific method – without which we would still be living in caves and wearing animal skins for warmth. Unfortunately however the tendency of most researchers (probably unwittingly) is to draw wide and sweeping conclusions from limited testing on limited data. This is especially prevalent in financial market research and is not limited to that research aimed at the retail market; weighty and didactic tomes aimed at sophisticated institutional investors can be equally misleading.
Most of this website is at present devoted to a systematic approach to trading individual stocks which I have rather preposterously called the “Smart Beta Rotational Stock Momentum System”. For many years my trading and my research have been based on the belief that momentum is a real phenomenon in financial markets which can be relied upon to produce profit provided one runs profits and cuts losses. Worryingly, no one can come up with a definitive explanation for why momentum exists and some deny that it does exist.
Have I done enough testing on enough data to convince myself that my system represents some sort of reality and will remain profitable in future years? The answer is no, not yet and perhaps not ever.
Can such certainty or at least a high degree of probability ever be achieved? Are financial markets deterministic or random? Are they perhaps deterministic but practically speaking unpredictable? I cannot answer any of these questions definitively and nor can anyone else. At present. Perhaps not ever.
Where have I failed? Where have I been slapdash? Primarily I am not satisfied that I have tested the system over enough stocks and over a long enough period. I have concentrated mostly on US listed stock data and my data provider has few stocks with a daily price history going back beyond 1962. I believe that CRSP has NYSE daily listed stock data going back in some cases to 1921 and clearly it is important to obtain as much data as you can going back in time as far as possible.
But even then markets change and data from 1921 may not necessarily be relevant to trading today’s market. For instance my published research on the futures markets show that trend “efficiency” has deteriorated steadily over the past 40 years: the increased noise from ever increasing participation in these markets has made it ever more difficult to profit from momentum trades, hence perhaps the less than inspiring recent 5 year performance of many of the leading Commodity Trading Advisors.
I have a sneaky feeling that there IS an inherent order to the universe (including even that part of it we call the financial markets) but we are still a long way from discovering it. And I don’t mean god – I’m an atheist.
But look, let’s get to the point – enough tendentious and self-opinionated waffle.
I have spent the past couple of weeks looking at “market timing” and “asset allocation” and have looked at a number of well written papers on the topic. In particular it is frequently claimed that you can achieve better risk adjusted and/or absolute return by exiting the market during a downturn and re-entering when the storm subsides. On a fully mechanical basis. I have made such claims myself but have seriously come to wonder whether the suggested process has been or will be robust over the long term.
Why? Well, briefly, a friend in Singapore set a hare running a couple of weeks ago when he mentioned a concept called “Dual Momentum”. Nothing new here – get out when momentum turns down, get back in again when it turns up. Nonetheless my friend pointed me towards a well written paper which lead me down the avenue of “trading the equity curve”.
For the uninitiated “trading the equity curve “is exactly the same approach. Stop your trading/trading program/investment/whatever when the market turns sour – you hope to achieve lower drawdown and volatility and higher CAGR. Hope.
I used a 12 month lookback. Put simply, if today’s price level dips below that of 260 trading days ago, cease trading. When (if) today’s price exceeds that of 12 months ago, re-commence trading. And yes, I studied many different lookback periods and many different methods including all the usual smoothing tools such as moving averages of price.
I also tested the approach on many different instruments and trading schemes. Over many different time periods. And no – I cannot claim I have looked at “enough” instruments” or enough time periods.
After two weeks of intense coding and back testing what I can claim is as follows:
Sometimes it works, sometimes it doesn’t!
I will post just two examples.
Both examples use exactly the same system with exactly the same (large) portfolio of ETFs and identical parameters except in one respect: the day of the month on which re-allocation takes place. Take a good look and remember these two examples differ only in terms of the monthly re-allocation date.
Believe me, much more extreme examples came up in my research.
Using Date 1 as a re-allocation date suggests that using this risk on/ risk off method could yield an almost identical CAGR for lower volatility and a lower drawdown. Using Date 2 as a re-allocation date strongly suggests otherwise. Too little data leads inexorably to curve fitting and incorrect, overly optimistic conclusions.
So very many websites out there claim success based on the use of a risk on/risk off methodology on a tiny handful of indices or ETFs. Even if they (usefully) back test over different time period (albeit never going back far enough since the data is not available) the conclusions have to be misleading. So what if swapping between the Lehman 20 Years US Bond Index and the S&P 500 monthly based on momentum has worked (in theory ) over the past 20 years? That is no guarantee the relationship and correlation will hold over the next 20, whatever economic theory might suggest. It should, it may, but will it?
The only conclusion you can draw is that only maximum diversification will give you a chance of success over the long term even if this does mean a lower, watered down CAGR.
Use multiples of everything. Stocks, bonds, currencies, other asset classes ,investment methodologies (mechanical or otherwise) geographies, service providers, banks, brokers, custodians…need I go on. You can never know what will implode/explode or when – only that it will, with monotonous regularity.
I have no doubt that many will take a different view. But for what it’s worth, that’s mine.