Stocks were hammered again on
Monday as the momentum names continue to be punished. The question of the day,
of course, is if the huge declines seen recently in names like Amazon.com,
Tesla, Twitter, and Yelp will cause the “meaningful correction” in the broad
market indices that just about everybody on the planet is looking for.
Frankly, I don’t know the
answer to this question. I can say that there doesn’t appear to be a
fundamental driver for the current shellacking, other than some high flying
stocks coming back down to earth, that is. My personal view is that either this
decline, which for the record, finished its second day on Monday, becomes a
self-fulfilling prophecy and people decided to panic out of stocks, or… this
ends pretty quickly. But, the bottom line is that this is merely one man’s
opinion.
We could spend the rest of our
pixels this morning making predictions about what is likely to happen next.
But, since we prefer to play the hand that has been dealt instead of guessing
what might come next, I thought it might be a good time to make good on my
promise to offer up an idea or two on how to get the really big moves in the
market right (and no, a decline of 2.5 percent does NOT qualify as such).
Getting the BIG Moves
Right
Late last week, we discussed
the importance of getting the really big, really important moves in the stock
market right. We looked at the past 20 years and found that investors would
have made a pretty penny staying invested in the stock market. In fact, from
6/1/1994 through the beginning of April, a buy-and-hope investor in the S&P
500 cash index would have made +325.14 percent.
We went on to note that
although a gain of +325 percent is nothing to sneeze at, one COULD actually do
much better if they managed to capture 70 percent of the bull market gains and
avoided one-half of the bear market losses. We did some math and found that
while such an approach missed a fair amount of upside and got hit with some of
the downside, the +325 percent gain could hypothetically be improved to +450.5
percent.
Graphically, such an approach
is kinda/sorta illustrated in the chart below as the first rectangle drawn on
the monthly chart of the S&P 500 covers about 70 percent of the bull market
gain. In essence, the game plan it to grab “the meat” out of the major
uptrends.
S&P 500 Monthly from 1994
Of course, one of the caveats
we have discussed is that achieving such a result is easier said than done, as
it is very tricky to (a) get the turning points correct and (b) avoid getting
faked out when a substantial correction occurs.
So, we had promised to provide
an idea or two that could help investors get the really big, really important
moves right.
A Simple Monthly
Trend-Following System
Before we launch into the
approach, we should state that what we are about to present is a very simple
system and that all results presented are purely hypothetical. The numbers in
this report do not represent actual trading and do not take into account
commissions, taxes, slippage, interest on money market etc. We should also note
that we do not utilize this specific approach at our shop as there are
definitely pitfalls to using any single indicator.
However, if all an investor
wants to do is stay on the right side of the really big moves, this simple
monthly trend-following approach does the job, for the most part. And the good
news is the investor would only need to look at the market on the last day of
each month.
The idea is to apply a
16-month, weighted, moving average to a monthly chart of the S&P 500. Then
we move the moving average forward 5 months. You can think of this as sliding
the moving average to the right a bit. The moving average is the blue line on
the chart below.
S&P 500 Monthly from 1995
In case you are not familiar
with the concept, moving the MA forward helps avoid whipsaws, such as the 1998
emerging markets crisis that wound up spanning just a couple of months.
The Strategy
The idea is simple. If at the
end of each month, the S&P 500 is above the 16-month, weighted, moving
average that has been moved forward 5 months, you remain invested in the
S&P. And if the S&P is below the MA, you stay in cash. Easy, right?
Below is a chart showing the
hypothetical monthly results of using such a strategy from 1995 through
3/31/2014. Again, this is a backtest of the strategy and should be used for
“proof of concept” only.
As you can see, the simple
monthly trend-following system does indeed improve results over the
buy-and-hope approach: +546 percent vs. +308 percent.
The cumulative return is also
little better than our original goal of capturing 70 percent of the upside and
missing half of the downside, which produced a hypothetical gain of +425
percent over a similar period.
In reviewing the annual returns
of the hypothetical backtest, you can see that the system wound up losing money
in 2000 but then stayed in cash during the remainder of the 2000-02 bear
market. As such, the system lost -10.5 percent during the bear market, which is
a big improvement over the market’s decline of more than -40 percent.
Then in 2008, the system lost
just -1.44 percent versus the -38.5% decline seen in the S&P 500. Thus, it
is clear that such a system did a nice job in preserving capital in the two
brutal bears that occurred since the turn of the century.
What’s the Catch?
However, the trade-off to the
approach is quite evident in 2003 and 2009. In order to avoid getting whipsawed
during the big, bad bear markets, such an approach is always going to be a bit
late in getting you back into market after the bear has ended. Therefore,
underperformance during the year following a bear market is to be expected.
Then the other problem with
such a system is a year like 2011, where the market first moved down violently
and then moved right back up in an equally violent fashion over a very short
period of time. Thus, the quick whipsaw created a fairly substantial loss on the
year.
But again, all in all, the
system does a pretty good job of accomplishing our base-level goal.
But Can’t We Do Better?
Everyone who has ever tested a
system for managing the stock market knows that once you find something that
works, the next step is to see if you can improve on the concept.
So, tomorrow, we’ll take a look
at taking this simple, monthly trend-following system up a notch or two by (1)
incorporating short positions into the mix and then (2) adding some leverage.
Positions in stocks mentioned:
none
The opinions and forecasts
expressed herein are those of Mr. David Moenning and may not actually come to
pass. Mr. Moenning’s opinions and viewpoints regarding the future of the
markets should not be construed as recommendations. The analysis and
information in this report is for informational purposes only. No part of the
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Portfolio constitutes a solicitation to purchase or sell securities or any
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