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THE STOCK MARKET'S EXTRAORDINARY VOLATILITY over the last week has prompted momentum investors to question the wisdom of their approach.
It was all well and good to bet on high momentum stocks when the market was rising. But when the market suddenly reversed course -- especially on Thursday, when the Dow suffered a dramatic intra-day 1000-point plunge -- those previously high-flying stocks were among the biggest casualties.
But it would be a shame if investors therefore decided to give up on momentum investing altogether. The approach has a stellar long-term record, even after taking setbacks such as this past week's into account.
Better yet, there may be a way for investors to couple momentum strategies with a timing system that goes to cash whenever momentum is about to stop working. Believe it or not, this turns out to be easier than you may think.
Let's start by reviewing momentum's historical record, as compiled by University of Chicago professor Eugene Fama and Dartmouth professor Ken French, two of the most acclaimed financial academics working today.
For every month since 1927, they calculated the return of a portfolio that owned the 30% of stocks with the best 12-month return through the end of the previous month -- and which shorted the 30% with the worst returns. This portfolio gained an average of 0.7% per month over the more than eight decades analyzed -- 8.7%, on an annualized basis.
Note that the professors didn't take transaction costs into account, so net of such costs this portfolio's return would have been somewhat less. But also note carefully that their hypothetical portfolio was market neutral -- always equally balanced between long and short positions. So whatever gain remains after paying for transaction costs can be considered to be a market-beating return.
That's the good news.
To appreciate how poorly momentum approaches can perform when the market's trend turns, however, consider how the professors' portfolio performed a year ago, just as the new bull market was taking off. At that time, of course, the stocks with the greatest momentum were those that had performed the best during the previous bear market. During the spring and summer of 2009, such stocks greatly underperformed those stocks that had been the bear market's worst performers -- which were skyrocketing.
From March through August of 2009, the professors' portfolio lost more than half its value -- 54.1%, to be exact.
Ouch. That's a huge loss over any period, much less just six months.
You might despair at finding some system that would consistently alert momentum investors to periods like the one that lasted from March through August of last year. After all, if we knew when the market's major trend was changing, then we wouldn't need momentum strategies to make money -- we could clean up simply by buying or shorting an index fund on margin. In any case, I hope it is needless to say, no one has shown the ability to consistently pinpoint those times when the market's major trend is changing.
Not all hope is lost, however. It turns out that we don't have to be a market timer to identify periods in which momentum strategies are unlikely to work. All we need to do is identify periods of high volatility which, almost by definition, are periods in which momentum strategies won't work very well. And, fortunately, because periods of high volatility tend to be clustered together, this is relatively easy to do.
Consider the performance of a hybrid portfolio that coupled momentum with a volatility-avoidance strategy. Whenever the VIX was above 30 at the end of a given month, this portfolio was out of stocks for the following month, earning the risk-free rate of return. Otherwise, it pursued the momentum strategy outlined above -- buying the 30% of stocks with the best trailing 12-month returns and shorting the 30% with the worst returns.
This hybrid portfolio did 3.4 percentage points per year better than the pure momentum approach, while nevertheless reducing risk by a third. That's a winning combination.
I present these results for illustration purposes only. I point this out not only because I'm not an investment advisor and cannot recommend any one specific approach. I say this also because there undoubtedly are better ways of devising a volatility avoidance strategy than automatically going to cash whenever the VIX rises above 30.
I can imagine that any of a number of technical trading rules might be useful in determining when the VIX is about to rise, for example, such as comparing the VIX to its 50-day moving average. I have not tested any alternate rules.
Still, my general points should be clear:
Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.
Comments? E-mail us at online.editors@barrons.com
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