Momentum: a different approach to buying stocks at the highs

An alternative title for this post could be, the internet rediscovers momentum and hates it, episode 5,000….

Meb Faber posted the other day on a strategy that buys stocks only at their all-time highs and otherwise holds bonds the rest of the time. The strategy has great risk-adjusted returns. It’s a great post, check it out. Also, AllocateSmartly put it through their backtest methodology in a post yesterday. Jake at Econompicdata wrote about it a few years back and I did as well about two years ago.

Meb takes a bit further and uses a bunch of other assets besides stocks to make the point even stronger. There was a lot of skepticism on what basically amounts to a momentum strategy. Or you can call it a trend following strategy. It’s just a different way of measuring asset price strength. Every time this comes up there is tons of disbelief. Yet, on the other hand, if you post the results of some value based strategy and its outperformance, most people are in agreement. Yeah, of course value outperforms. Maybe this is why momentum remains the premium factor by far as I showed in my post. Anway, I wanted to post on a slightly different version of the buy at the highs strategy that eliminates a few of its big drawbacks.

Probably the biggest drawback of the buy at the highs strategy is that it is holding bonds most of the time, about 70% of the time. So, you’re only invested in the highest returning asset class over the long term a third of the time. Like AllocateSmartly put it, “The strategy holds stocks less than 30% of the time, so this is really a bond strategy that selectively holds stocks when they’re showing extreme strength.” Going forward this is going to matter a lot more as bonds today are priced for way lower returns than in the past. As you’ll see in a minute the returns to the buy at the highs strategy have decreased over time (see table below), at least since the early 1970s, as bond yields have decreased. No surprise there. Now, let’s take the spirit of the buy at the highs strategy and apply the concept a bit differently.

In this modified approach, what I call the ‘Less than 10% DD’ (drawdown) strategy, we’re going to buy and hold US stocks (SPY), when the drawdown of the index (SPY) is less than 10% measured on a monthly basis. When the index is in a drawdown of greater than 10%, then the strategy switches to a trend following model using the 6 mo SMA. The trend following side of the strategy is in SPY when the index is above its 6 mo SMA, and in bonds (IEF), when it is below it’s 6 mo SMA. Basically, we switch from a buy and hold approach to a trend following approach based on the state of drawdown of the index. That’s it. This strategy ends up holding stocks about 70% of the time and bonds about 30% of the time. Returns and drawdowns are posted below and I compare them to my calculations for the buy at the highs strategy.

By being exposed to stocks the majority of the time, instead of bonds, the Less than 10% DD strategy has higher drawdowns, but much higher returns. By measuring momentum a bit differently but still with the goal of protecting the downside, this approach is just another way of buy and holding strength.

That’s about it. As Meb, Jake, and AllocateSmartly, mentioned in their posts this is not an endorsement of this approach over others – there are way better ways to implement TAA strategies as we all show, but that stock price strength in general, the majority of the time, begets more strength. Or in other words, momentum works and there are lots of ways to go implementing it!