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Climbing the Wall of Worry


Our LC Momentum model holds stocks as its core position. Long term empirical evidence across global equity markets shows equities significantly outperform all other major asset classes since 1900[1]. Morgan Housel recently published an article about the last seventy years of US stock market returns, and how they have to regularly climb the wall of worry.

Keep in Mind, Stocks Rose 1,100-fold During This Period

 

From Morgan’s article:

 

The S&P 500 rose 1,100-fold over the last 70 years, including dividends. But look what happened during that period:

 

  • May 1946 to May 1947. Stocks decline 28.4%. A surge of soldiers return from World War II, and factories across America return to normal operations after years of building war supplies. This disrupts the economy as the entire world figures out what to do next. Real GDP declines 13% as wartime spending tapers off. A general fear that the economy will fall back into the Great Depression worries economists and investors.
  • June 1948 to June 1949. Stocks decline 20.6%. A world still trying to figure out what a post-war economy looks like causes a second U.S. recession with more demobilization. Inflation surges as the economy adjusts. The Korean conflict heats up.
  • June 1950 to July 1950. Stocks fall 14%.North Korean troops attack points along South Korean border. The U.N Security Council calls the invasion “a breach of peace.” U.S. involvement in the Korean War begins.
  • July 1957 to October 1957. Stocks fall 20.7%. There’s the Suez Canal crisis and Soviet launch of Sputnik, plus the U.S. slips into recession.
  • January 1962 to June 1962. Stocks fall 26.4%. Stocks plunge after a decade of solid economic growth and market boom, the first “bubble” environment since 1929. In a classic 1962 interview, Warren Buffett says, “For some time, stocks have been rising at rather rapid rates, but corporate earnings have not been rising, dividends have not been increasing, and it’s not to be unexpected that a correction of some of those factors on the upside might occur on the downside.”
  • February 1966 to October 1966. Stocks fall 22.2%. The Vietnam War and Great Society social programs push government spending up 45% in five years. Inflation gathers steam. The Federal Reserve responds by tightening interest rates. No recession occurred.
  • November 1968 to May 1970. Stocks fall 36.1%. Inflation really starts to pick up, hitting 6.2% in 1969 up from an average of 1.6% over the previous eight years. Vietnam War escalates. Interest rates surge; 10-year Treasury rates rise from 4.7% to nearly 8%.
  • April 1973 to October 1974. Stocks fall 48%.Inflation breaks double-digits for the first time in three decades. There’s the start of a deep recession; unemployment hits 9%.
  • September 1976 to March 1978. Stocks fall 19.4%. The economy stagnates as high inflation meets dismal earnings growth. Adjusted for inflation, corporate profits haven’t grown for eight years.
  • February 1980 to March 1980. Stocks fall 17.1%. Interest rates approach 20%, the highest in modern history. The economy grinds to a halt; unemployment tops 10%. There’s the Iran hostage crisis.
  • November 1980 to August 1982. Stocks fall 27.1%. Inflation has risen 42% in the previous three years. Consumer confidence plunges, unemployment surges, and we see the largest budget deficits since World War II. Corporate profits are 25% below where they were a decade prior.
  • August 1987 to December 1987. Stocks fall 33.5%. The crash of 87 pushes stocks down 23% in one day. No notable news that day; historians still argue about the cause. A likely contributor was a growing fad of “portfolio insurance” that automatically sold stocks on declines, causing selling to beget more selling — the precursor to the fragility of a technology-driven marketplace.
  • July 1990 to October 1990. Stocks fall 19.9%. The Gulf War causes an oil price spike. Short recession. The unemployment rate jumps to 7.8%.
  • July 1998 to August 1998. Stocks fall 19.3%. Russia defaults on its debt, emerging market currencies collapse, and the world’s largest hedge fund goes bankrupt, nearly taking Wall Street banks down with it. Strangely, this occurs during a period most people remember as one of the most prosperous periods to invest in history.
  • March 2000 to October 2002. Stocks fall 49.1%. The dot-com bubble bursts, and 9/11 sends the world economy into recession.
  • November 2002 to March 2003. Stocks fall 14.7%. The S. economy puts itself back together after its first recession in a decade. The military preps for the Iraq war. Oil prices spike.
  • October 2007 to March 2009. Stocks fall 56.8%. The global housing bubble bursts, sending the world’s largest banks to the brink of collapse. The worst financial crisis since the Great Depression.
  • April 2010 to July 2010. Stocks fall 16%. Europe hits a debt crisis while the U.S. economy weakens. Double-dip recession fears.
  • April 2011 to October 2011. Stocks fall 19.4%. The U.S. government experiences a debt ceiling showdown, U.S. credit is downgraded, oil prices surge.
  • June 2015 to August 2015. Stocks fall 11.9%. China’s economy grinds to a halt; the Fed prepares to raise interest rates.

____________________________________________________________

 

I like Morgan’s article, it reminds us that economic uncertainty has always been a regular part of the past along with frequent corrections (10%+ declines) and deep bear markets (20%+ declines). His intention is to help us have a long term perspective. Many times throughout the past seven decades, “this has never happened before”.  Yet the US continued to show its strength and resiliency. For some, this is effective. For others, they need something more to help them follow their plan.

 

Dual Momentum

 

In the equities portion of our dual momentum model, we rotate among US Large, US Small, and International stocks based on twelve month relative strength momentum[2]. When all three asset classes have negative absolute momentum[3], we switch into bonds. The idea here is to earn the risk premium in stocks with less exposure to the downside volatility and bear market drawdowns that frequently have occurred in the past and will frequently occur in the future. We emphasize less in an effort to promote proper expectations. Empirical data suggests that dual momentum can be used to earn higher returns with less risk than buy and hold, but it’s not a Holy Grail. Holy Grail strategies tend to fall apart in real time because they were over fit to a limited amount of past data with no economic argument to support why they work. Researchers refer to this as data-mining. With dual momentum, we believe having a proven rules-based method in place to exit equities ahead of the majority of major bear market declines can be all that is needed to help investors have the confidence to stick with their strategy for the long term. And the right strategy for every investor is the one they will stick with. This is key.

 

Since Morgan is using data since 1946, we thought it would be fun to look at showing our dual momentum equities model during this same period (note: international is excluded in this example due to lack of data prior to 1970 although we use it in our actual trading model).

 

equity-chart.png.jpg

stats.png

 

Here are a few things to take notice of on both the chart and in the statistics. On the chart, it’s important to notice that our dual momentum approach did NOT outperform an equal weighted buy and hold portfolio in the first thirty years, but slightly lagged or matched buy and hold for most of the period. Thirty years is the investment time horizon for many investors, not seventy. If only relative strength momentum would have been used during this period, outperformance would have occurred. Absolute momentum, or trend following momentum, will take you out of the market at times when doing nothing would have ended up being the better short term outcome. We call these whipsaws, and they are expected as a short term price to pay for risk management that can allow us to sidestep the majority of painful bear market drawdowns.

 

Over the long term, relative strength and absolute momentum tend to contribute fairly equally to excess returns. If the future ends up looking more like this specific period of the past, we still would prefer dual momentum’s slight underperformance as a small cost to pay for the psychological comfort of knowing a plan is in place to protect capital against 50% drawdowns. The total outperformance of dual momentum in the last seven decades comes in the more recent four decades where three separate bear markets of 50%+ losses occurred for buy and hold investors. Two of these occurred in the last fifteen years. This is when absolute momentum does its job of taking us out of equities in the early stages of bear markets. Even during the first thirty year period, dual momentum still produced lower volatility and maximum drawdown[4], and a higher Sharpe Ratio. The period of 1946-1972 produced an annualized return of 12.1% for buy and hold and 11.78% for dual momentum, while over the entire duration dual momentum produced both higher returns and less risk.

 

We make clear to our clients that beating the market isn’t a financial goal, and it would be intellectually dishonest for us to suggest we can guarantee anything about the future. What we can guarantee is that we have vigorously researched a robust investing plan supported by decades of historical data and third party validation. When combined with disciplined execution and realistic expectations, we believe the probabilities are highly in favor of a successful long term investing experience.

  • Investigate carefully
  • Choose wisely
  • Follow faithfully

Fama/French (2008): Momentum is “the center stage anomaly of recent years…an anomaly that is above suspicion…the premier market anomaly.”

 

[1] The Credit Suisse Global Investment Return Yearbook shows how both US and World ex-US (in USD) equity risk premiums have far exceeded those of bonds and bills since 1900 forming the portfolio theory basis for focusing on equities in our dual momentum model.

[2] Relative strength momentum compares total returns of one asset class to another over an applicable lookback period. The asset class that has risen the most is held for the next month.

[3] Absolute momentum is defined as having a total return less than the risk free rate (such as US T-bills) over the applicable lookback period.

[4] Maximum drawdown measures total peak to trough loss suffered prior to reaching new equity highs. Maximum drawdown is much more important to most investors than the more frequently mentioned measure of risk known as standard deviation or annualized volatility.

 

Past performance doesn’t guarantee future results. The concepts of dual momentum were pioneered by the research of Gary Antonacci. We recommend using his best-selling book and blog as an additional resource for studying momentum. This is a hypothetical model intended to show the efficacy of dual momentum, and is not intended to represent specific investment advice. Data is gross of any applicable taxes and transaction costs, and investors should always consult with their tax advisor before investing. All investments carry risk, may lose value, and are not FDIC insured. We provide the hyperlink to Morgan Housel’s article as a convenience and do not endorse nor guarantee the accuracy of any information he has presented.

 

Feel free to contact us if you’d like to discuss your specific situation further. We welcome every opportunity to discuss how we could add value to your financial life.

 

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