Thursday, December 22, 2016

Using Absolute Momentum to Positively Skew Calendar Year Returns

There are instances where I "borrow" an idea from someone (actually... most of my posts were at a minimum inspired by someone else). In this case, I am stealing the initial concept from Ryan Detrick who posted the following chart of annual U.S. stock returns going back ~200 years as there is a lot of interesting information in his chart. As Ryan pointed out in a supporting post most returns were between 0% and 10%, but returns varied pretty broadly during recessions:

Yes, more recessionary years saw negative returns more often than not, but surprisingly there have been some strong equity returns during years that had an official recession take place. Obviously most of these big gains took place as the recession was ending; still, this is eye-opening and reinforces not focusing too much on just fundamentals, but also incorporating valuations and technicals.

I recreated his chart below using Ibbotson data going back to 1927 (the data goes back to 1926, but you'll see shortly why I selected 1927) and to highlight his point on recessions, I added yellow cells to show final years of a multi-calendar year recession to clearly show the strong performance available for investors that owned stocks after the stock market was already crushed during the initial stages of the recession. Note there are some differences in which years we show as being recessionary. I am not sure of Ryan's source, but I just went to Wikipedia.

Avoiding the Downturn and Capturing the Upturn

So is it possible to avoid much of the drawdown at the start of a recession and capture the rebound? 

Fortunately, it might just be. 

The below recreates the above table, but with one slight twist. Instead of a buy and hold allocation to U.S. stocks, the below utilizes the following allocation rules:
At each month-end, if the total return index is greater than the 10-month moving average of the total return index stay in stocks... otherwise buy U.S. treasuries.
The 10-month moving average calculation pushed the first calendar year of the strategy to 1927, hence the 1927 start in both charts.

Remarkably, while this simple model did reduce some of the strongest calendar years, it resulted in no calendar year return of less than -25% and "converted" most of the tough recession years to much more manageable down years. As remarkable, this simple momentum model was able to capture most of the rebound years (i.e. the yellow cells showing the last year of a multi-year recession), as well as the strong performance of the two positive returning recessions (1945 and 1980).