Stop worrying and learn to love momentum

The bull market in equities is seemingly never going to end and I get more and more questions about what people should do who have missed the boat and only partially invested in the current bull market.

The usual fear is that if they invest now, they might be investing at the top of the market. Another argument is that every asset class seems overvalued. Given extremely low-interest rates, bonds don’t seem a viable option, stocks aren’t cheap either and many alternative asset classes like infrastructure or REITs have become expensive as well. I have been a value investor for most of my career, but there comes a point when avoiding an asset class on valuation grounds or for fear of an imminent bear market becomes counterproductive. By standing on the sidelines for too long the opportunity costs in terms of foregone returns can become so big that it may take you years and even decades to make up for them.

Value investors and long-term investors, in general, tend to look down on traders, but there are a few things that long-term investors can and should learn from them. First of all, they should learn that time in the market is more important than timing the market. One can only make money if one is invested. But being invested comes with the inevitable risk of drawdowns, which can be short-term in nature like at the end of 2018, or a massive bear market like in 2008. To deal with these drawdown risks it is important to learn from short-term investors to respect and even love momentum. If price momentum goes against your position for too long, you should sell the position and buy it back at a later point in time when price momentum is more favourable again. There are many ways to integrate momentum into your investment process, but approaches like Meb Faber’s Global Tactical Asset Allocation or Gary Antonacci’s Dual Momentum approach are easy to follow for any investor. In a previous job, I have looked at different approaches like that from the perspective of a Sterling, Dollar and Euro investor and you can still find these papers here. The chart below summarises the value at risk over one year with a 95% level for a simple 60/40-portfolio vs. these two momentum-driven alternatives. The reduction in downside risks is dramatic for every currency.

Value at Risk for one year with a 95% confidence level

Source: Fidante Capital. Note: GTAA = Global Tactical Asset Allocation.

The maximum drawdown between 1998 and 2019 has also been massively reduced, showing that these momentum-driven strategies can help you avoid severe losses. If you are worried today about high valuations or the possible end of the current bull market, then the most important thing for you is to get into the market with a sensible plan to get out when momentum turns.

Maximum drawdown 1998 to 2019

Source: Fidante Capital. Note: GTAA = Global Tactical Asset Allocation.

And once you have done that, you can start fiddling around with your own momentum signals to get the best trade-off of reducing drawdowns and capturing upside potential. A group of practitioners from Research Affiliates, for example, have recently evaluated the performance of a mix of slow and fast momentum signals, where slow means a rolling 12-month absolute return signal and fast a rolling 1-month absolute return signal. The paper is available here. In their research, they were concerned about finding the best mix of getting out of down markets quickly while getting back in time to capture most of the upside of the recovery. They show that a slow momentum signal or a 50/50 mix between a slow and fast momentum signal leads to much better results than fast momentum signals. 

Risk-adjusted returns of fast and slow momentum strategies in global stock markets

Source: Garg et al. (2019).

But this is fine-tuning. The most important thing for investors today is not to be afraid of the bull market.