Sunday, September 12, 2010

The Power of Momentum

9/20 Update:

It looks like the results using Shiller's data are no good as Shiller uses monthly average data for his index (rather than month-end), which apparently morphs the results from positive to negative in this case. Many thanks to Michael from MarketSci blog for the info.

In looking at results using actual month-end data,
it looks like the only way a month-to-month momentum strategy has outperformed is with substantially higher down month triggers (between 5-10% down months).

Initial thoughts... downward momentum trading strategies likely only work in severe down markets. Otherwise, it is rather dangerous to short an asset class over the long term that tends to be noisy (i.e. volatile / mean-reverting) and "should" have a bias to rise over the long term.

Note: Updated figures, which changes the results.

All data used in the below charts created by EconomPic was adapted from historical S&P 500 data (index + dividends) from Irrational Exuberance. I have uploaded the adapted data to Google Docs and all three indices (total return, momentum, and momentum -1.85%) to share and to serve as a check (if there are errors, let me know) for all my readers here.

To the post...

Bank of England’s Andrew Haldane (hat tip Felix Salmon) with some rather jaw dropping analysis showing that a momentum investment strategy consisting simply of buying when the previous month was positive and shorting when negative, significantly outperforms a simple value investing strategy based on the dividend discount model.

The chart below is Andrew's (for more background on the chart, go here):

Felix ponders how the results would look relative to a simple buy and hold strategy:

Still, I would have loved to see a third line, showing the results of a simple buy-and-hold strategy. Sometimes the easiest things to do are also the most profitable of all.
Here it is (going back all the way to 1871)... it turns out that the easiest thing to do (i.e. a buy and hold listed below as 'total return') was NOT the most profitable by a factor of 80 (according to my calculations, a $1 investment in 1871 is worth ~$125,000 in a buy and hold strategy vs. ~$240,000 for the simple momentum strategy described above over that same time frame).

BUT, the reason for the huge discrepancy in return is due almost solely to what happened during the Great Depression, when a buy and hold investor would have lost more than 80% of their investment, while a momentum investor would have tripled their investment over that same period.

To show how huge an impact... if we take the same data starting in 1940 (i.e. post Great Depression), the buy and hold "total return" investor would have actually outperformed by a factor of more than 8 (~$1350 vs ~$150).

BUT.... when one data mines the historical data (always a fun thing to do) and only shorts the market following monthly returns down more than 1.85% (prevents whipsawing I guess), the momentum strategy is a huge winner turning $1 from 1871 into more than $7,000,000 dollars today and significantly outperforming a buy and hold investment both pre and post 1940.

Source: Irrational Exuberance