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).

Betting on Perfection

To earn a decent return going forward, how reliant on multiple expansion are buy and hold investors in the S&P 500? Let's take a look at one measure.

The first chart plots forward 10-year returns for the S&P 500 at various starting 5 point "CAPE" valuation buckets (i.e. less than 10x P/E all the way through above 30x) against the change in the starting P/E relative to the P/E in ten years (i.e. whether the P/E multiple expanded or contracted) going back to Ibbotson data inception in 1926. The chart shows the strong relationship between forward performance and the change in the multiple, as well as the impact of the starting valuation (the cheaper the starting valuation, the higher the returns and the more likely the index will exhibit multiple expansion, whereas the more expensive the starting valuation, the lower the returns and the more likely the index will exhibit multiple contraction).

The next chart plots the same information, but uses forward real returns (i.e. adjusted for inflation). It is interesting to see the tight convergence of returns during periods of P/E multiple contraction irrespective of starting valuation, indicating that some of the decent nominal returns during contractionary periods in the first chart at lower starting valuations occurred during inflationary environments (mainly the 1970's).

So where do we currently sit... at the current 28.3x CAPE, decent forward returns will require the multiple remaining elevated (or becoming more elevated) as no change would equate to a roughly ~4% real return in the model. While no change is certainly a possibility, the below chart shows the CAPE has declined in all previous 67 ten year periods since 1926 when the CAPE was greater than 28x, with an average and median decline of around 40% (which would take us right back to the historical average of ~18x), which at the current valuation models out to a roughly 0% real return over 10 years.

None of this is a sure thing, especially over the short-run. Despite being expensive three years ago, the S&P 500 has returned 10% annualized since. It just happened to have benefited from moving from the 15th percentile of most expensive CAPE to the 6th most expensive. While it absolutely can get more expensive from here, that's simply not the long-term buy and hold bet I would want to make when there are cheaper opportunities available outside and within the U.S..

A Dynamic Approach to Factor Allocation

ETF Trends (hat tip Josh) showed the following "quilt" of large cap factor calendar year returns in the post Low Volatility is Not a Buy and Hold Strategy.

Author John Lunt's takeaway (bold mine):

It is reasonable to conclude that low volatility is not a buy and hold strategy. This is not because it is unlikely to outperform over the long term, but rather because few investors are likely to survive multiple years of underperformance. Recent months have witnessed money flowing out of the low volatility and minimum volatility ETFs. Is this money flowing into different factor ETFs, or is it moving back to the market cap-weighted ETFs? Rather than abandoning factors during their periods of underperformance, investors may want to consider the opportunities that exist in factor blending and in factor rotation.

I agree completely and in this post I'll outline one potential framework to allocate to factors that diversifies across a few approaches and across time. Update: following my publishing of this post I received a comment that a lot of the work in the below was built out in further detail in a white paper by Ronald Balvers and Yangru Wu titled Momentum and Mean Reversion Across National Equity Markets. I recommend anyone interested in the framework to take a deeper look there.

QUICK BACKDROP

For simplicity, I used the same indices outlined in the ETF Trends post with the exception of the below two tweaks:

1. I added a small cap index (S&P 600 Smallcap Index)
2. I swapped out the S&P 500 Dividend Aristocrat Index for the MSCI USA High Dividend Yield Index; the issue with the S&P 500 Dividend Aristocrat Index for this analysis is that it has a size tilt (it's equal weighted) and a momentum / quality tilt (it holds companies that have increased dividends every year for the last 25 consecutive years built in as well). Neither are a bad thing at all, just not the pure dividend exposure I want for this analysis.
3. I went back another five years (which does bring up an important boom / bust regime for the analysis)

Similar to what was outlined in the ETF Trend piece, certain factors had more favorable long-term returns over 15 and 20 years (small cap, low volatility, momentum, and high dividend), while high beta and value (of all things) weighed on performance (note that the Russell 1000 Value Index outperformed the S&P 500 Value Index used in the analysis by 100 bps, which shows that getting the factor right may not be enough if you get the implementation part wrong - but I'll save that for another day). 

The below shows the updated factor quilt. Note the quality index only went back 15 years, hence the blank 1996-2000 data.

FACTOR ROTATION: MOMENTUM OR MEAN REVERSION? YES AND YES.

Intermediate Time Frames: Momentum is the Winner

Momentum tends to work better over shorter periods of look back periods (6, 9, 12 months). The chart below shows momentum and mean reversion using 12-month  returns for the indices and one can see that momentum outperformed over the longer time frame. That said, note that almost all of the outperformance came in the first 10 years as a relative momentum strategy was able to cruise through the dot.com bubble.

Longer Time Frames: Mean Reversion is the Winner

Mean reversion on the other hand tends to work better over longer look back periods, in part because valuations tend to matter more over longer time frames (while sentiment is a shorter term signal). We can see that momentum continued to outperform the index over this twenty year period, but not nearly to the extent it had using a shorter signal.

Combining Signals

Given momentum works better over shorter periods and mean reversion works better over longer periods, we can combine the two to diversify allocations by the momentum factor and by time. The result is a portfolio with similar returns, but much more consistent tracking to the S&P 500 (tracking error goes from 9.5% for mean reversion and 8.3% for momentum, to 5.8% for the combination).

Taking it one step further, the below adds cash as an allowable asset class for momentum (i.e. an allocation can only occur if the twelve month return outpaced cash), turning momentum into a more absolute return oriented strategy (mean reversion continues to exclude cash as an asset class).

There are still shorter periods of time in which the blend will underperform, but the blended strategy (with the ability to go to cash) has provided consistent outperformance over three year periods (85%  of the time over the last twenty years). In addition, the relative performance has tended to have a linear relationship with starting valuation (i.e. it tends to outperform going forward when stocks appear relatively expensive) in part because of the ability to move to cash in the case of momentum and in the likelihood of allocating to a less frothy segment of the U.S. stock universe in the case of mean reversion. Something to keep in mind given the current cyclically adjusted P/E "CAPE" has crossed 27x.

CONCLUSION

Certain factors have shown the ability to outperform over longer periods of time, but can and do underperform over shorter periods. These periods can be challenging for investors that cannot remain disciplined. As a result, a strategy that consistently follows a set of diversified rules to allocate across factors may help reduce behavioral issues of holding onto a strategy that differs from the S&P 500. Given the historical performance of this sort of strategy tends to do relatively better when market valuations are expensive, it may be an interesting approach to allocate across factors going forward.