Understanding Momentum

Since its initial discovery by DeBondt & Thaler in 1985, the momentum effect has been documented and researched in many markets worldwide. Stocks which have outperformed in the recent past tend to continue to perform strongly over the months ahead.

Research conducted by Dr Bruce Vanstone and me indicates that Momentum significantly outperforms the major benchmark indices in both US and Australian markets. Investors, however, tend to focus on the annual rate of return without considering the accompanying volatility. Consider our simulation of Twiggs Momentum on the S&P 500 for the period January 1996 to June 2013 as an example.

Dark green areas represent cash holdings, when market risk is identified as elevated. The blue line represents the benchmark S&P 500 index. Click on the image if you need a larger view.

Investment Strategy:	Twiggs Momentum	Buy & Hold
Starting Capital (USD):	$100,000	$100,000
Ending Capital (USD):	$4,871,686.27	$258,649.35
Annualized Gain:	24.89%	5.58%
Total Commission Paid (at 5 BPS):	$66,194.35	$49.96
Number of Investments:	331	1
Win Rate:	54.38%	100.00%
Average Profit:	44.16%	158.79%
Average Loss:	10.15%	0.00%
Maximum Drawdown:	38.64%	56.77%
Maximum Drawdown Date:	9/11/2006	3/9/2009
Sharpe Ratio:	0.98	0.42

Investors tend to focus on the annualized gain of 24.89% p.a. without really applying their minds to the other statistics in the table. Maximum Drawdown of 38.64%, while lower than the index, means the portfolio is still subject to gut-wrenching volatility. Soaring gains are often followed by sharp falls and it takes strong resolve to stick with the strategy after one of these setbacks. Many investors would have abandoned ship after the first major drawdown in early 2000.

Another factor is the Win Rate of just above 54% which means that over 45% of all stocks purchased are sold at a loss. These are typical statistics for a momentum strategy, but investors can expect a high percentage of stocks to be cut from the portfolio for failing to adhere to the expected growth path. The strength of the strategy, however, is the expected gains on stocks that do adhere to the momentum growth path, with average profits exceeding average losses by a ratio of almost 4 to 1. That is where the excess returns are generated and is the reason why the strategy outperforms the benchmark index.

There are also extended periods where the portfolio remains in cash — long enough for doubts to grow as to whether momentum still works in the markets. My own view is that momentum strategies have been shown to outperform the Dow over the last 100 years and are likely to remain viable for as long as we have stock market cycles.

Coping with the emotional roller-coaster ride of investing in stocks is never easy, but here are some hints.

Focus on your investment time horizon of at least 5 years.
Check stock prices no more than once a week. Tracking prices daily or more frequently tends to cloud your judgement.
Welcome gains ahead of long-term averages, but expect them to fade over time.
If something unusual occurs, step back from the market, examine the long-term history, and ask: “Is this really unexpected or were my expectations unrealistic.”

That’s all for today. Take care.

May 8, 2014

Is the market overpriced? Episode III

US markets look pricey when we compare market capitalization to GDP. Why is the market ignoring this?

The S&P 500 is trading on a reasonable forward Price-Earnings Ratio (PE) of 15.17, but this forecasts a 23% jump in earnings over the next 12 months. Current as reported PE of 18.64 also assumes strong earnings growth.

S&P 500

Margins are growing:
S&P 500

But sales growth close to zero warns that earnings may falter:
S&P 500

Book value is surprisingly growing faster than sales, suggesting that corporations are hoarding assets rather than distributing profits to shareholders:
S&P 500

Causing asset turnover (sales/book value) to fall:
S&P 500

Which is why the valuation metric of Price to Book Value remains within reasonable bounds:
S&P 500

If management are unable to improve asset turnover — through improved sales or new investment — stockholders will start clamoring for higher distributions. Which may be one reason for high stock prices.

The second reason is that, with interest rates, tax rates and real wages at historic lows, corporations are likely to make fat profits over the next few years and stocks remain reasonably buoyant. But at least one of these factors can be expected to change in the next decade: recovery of the housing market would cause the Fed to lift interest rates; a revision of the tax code by a President who can work with both sides of the House; or a dramatic fall in exchange rates placing upward pressure on (real) wages as manufacturers regain export markets. The impact of any change will depend on how well the economy has recovered.

I will be watching sales growth, profit margins and asset turnover with interest over the next few quarters to see how this plays out.

January 29, 2014

How I Can Explain 96% Of Your Portfolio’s Returns | Kiran Pande

Great article from Kiran Pande:

Since the 1960s, we’ve been dependent on a model called CAPM (capital asset pricing model) to understand the relationship between risk and return, despite the fact that its measure of risk only explains about 70% of return. This measure, beta, makes the assumption that the entirety of every stock’s return is due to its exposure to the market. Put simply, every stock’s returns will equal a factor of the S&P 500’s returns. Thus, if a stock’s beta is 2.0, it will double the S&P 500’s returns on a bull day and double its losses on a bear day. Obviously, this assumption is wrong almost every day, but the idea is that this factor is explaining most of a stock’s returns.

All returns not explained by beta in the CAPM model are called alpha. This is traditionally accepted as the level of skill and value added by a portfolio’s manager……

There is a whole laundry list of reasons not to use CAPM, beta, and alpha but here are some highlights…

70% is not 100%, not even close

Beta is symmetrical, risk is not… downside risk is rarely the same as upside risk.

Since the market index used to calculate beta (usually the S&P 500) contains stocks whose returns are supposedly dependent upon beta, these stocks’ returns are somewhat dependent upon themselves.

These counterpoints do not render beta, alpha, and CAPM useless, but we can do much better. The Fama-French Three Factor model is the answer. Rather than a single factor (market performance), the model throws a size factor and a value factor into the mix, replacing much of the nebulous alpha term. With the addition of these factors, Fama and French boast that their model explains as much as 96% of returns with quantifiable measures.

November 16, 2013

What’s New: Twiggs Momentum research results

Further to my recent part-acquisition of Porter Capital Management, I would like to share with you our progress in developing new investment strategies.

Quarterly Performance

Firstly, Porter Capital’s ASX200 Prime Momentum strategy achieved a 38.43% gain for the 12 months ended 31st October 2013, out-stripping the total-return index by 12.95% (performance is measured after brokerage costs but before fees and taxes which vary according to portfolio size and commencement date).

Twiggs Momentum

We have also completed testing of strategies using Twiggs Momentum to identify top-performing stocks. Twiggs Momentum is a specialized momentum indicator developed by me and used extensively in my Trading Diary. Test results way exceeded our expectations.

Market Filters

Just as important, we have expanded our use of macroeconomic and volatility filters to help preserve capital during sustained bear markets.

I have long been opposed to mechanical trading/investment systems on the grounds that no one system is suited to all market conditions. To overcome this, Dr Bruce Vanstone and I developed a new approach employing filters to identify when market risk is elevated, so the portfolio can be moved to cash and/or government bonds.

S&P 500

Historical simulation of $100,000 invested in S&P 500 stocks since January 1996 using our Twiggs Momentum strategy returned an average of 24.89% p.a. Dark green areas represent the move to cash when market risk is elevated. The blue line represents the benchmark S&P 500 index.

Click on images to enlarge.

ASX 200

Historical simulation of $100,000 invested in ASX 200 stocks since January 2000 using Twiggs Momentum strategy returned an average of 23.77% p.a. Dark green areas represent the move to cash when market risk is elevated. The blue line represents the benchmark ASX 200 Accumulation Index.

Click on images to enlarge.

The Momentum Effect

Since its initial discovery by DeBondt & Thaler in 1985, the momentum effect has been documented and researched in many markets worldwide: stocks which have outperformed in the recent past tend to continue to perform strongly.

Investment Research & Systems

All strategies are developed and rigorously tested by Dr Bruce Vanstone, head of investment research, and myself to ensure their suitability for local market conditions. And all systems are rule-based to ensure decision-making is disciplined, unemotional and objective.

Porter Capital

Porter Capital manage funds for high net worth investors and independent financial advisers. We currently manage funds in individual accounts across two adviser platforms, Hub 24 and Mason Stevens, offering investors five key benefits:

Beneficial ownership of your underlying investments;
Online access (24×7) to your portfolio;
Comprehensive tax reporting;
Brokerage at wholesale rates; and
Portfolio and risk management by a team of market specialists.

Momentum is an active strategy suitable for lower tax vehicles such as self-managed or self-directed superannuation, pension or retirement funds. The strategy complements and diversifies other equity strategies, smoothing overall portfolio returns. Within this context, the ASX200 Prime Momentum strategy enhances Core and Satellite equity exposure where the objective is diversification of style and strategy.

A Word of Caution

Results that look too good to be true, normally are. No market filter can provide 100% protection against market down-turns, and simulations carried out on data history are no guarantee of future performance. Diversification, across markets and strategies, is important to spread risk, but you must consider your overall risk profile. Please consult your financial adviser for advice tailored to your specific needs.

We will be visiting major cities in Australia in the next few months and look forward to updating readers on our latest research and performance. For more details, visit our website at Porter Capital Management.

If you do what you’ve always done, you’ll get what you’ve always gotten.

~ Tony Robbins

Disclaimer

Porter Capital Management Pty Ltd is a Corporate Authorized Representative (AR Number 300245) of Andika Pty Ltd which holds an Australian Financial Services Licence (AFSL 297069).

Porter Capital Management (PCM) has made every effort to ensure the reliability of the views and recommendations expressed in the reports published in this newsletter and on its websites. Our research is based upon information known to us or which was obtained from sources which we believe to be reliable and accurate.

No guarantee as to the capital value of investments, nor future returns are made by PCM. Neither PCM nor its employees make any representation, warranty or guarantee that the information provided is complete, accurate, current or reliable.

You are under no obligation to use these services and should always compare financial services/products to find one which best meets your personal objectives, financial situation or needs.

The information in this newsletter and on this web site is general in nature and does not consider your personal circumstances. Please contact us or your professional financial adviser for advice tailored to your needs.

To the extent permitted by law, PCM and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special or consequential loss or damage) arising from the use of, or reliance on, any information. If the law prohibits the exclusion of such liability, such liability shall be limited, to the extent permitted by law, to the resupply of the said information or the cost of the said resupply.

Important Warning About Simulated Results

Porter Capital Management (PCM) specialise in developing, testing and researching investment strategies and systems. Within this newsletter and the PCM Web site, you will find information about investment strategies and their performance. It is important that you understand that results from PCM research are simulated and not actual results.

No representation is made that any investor will or is likely to achieve profits or losses similar to those shown.

Simulated performance results are generally prepared with the benefit of hindsight and do not involve financial risk. No modelling can completely account for the impact of financial risk in actual investment. Account size, brokerage and slippage may also diverge from simulated results. Numerous other factors related to the markets in general or to the implementation of any specific investment system cannot be fully accounted for in the preparation of simulated performance results and may adversely affect actual investment results.

To the extent permitted by law, PCM and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special or consequential loss or damage) arising from the use of, or reliance on, any information offered by PCM whether or not caused by any negligent act or omission.

October 27, 2013

Saving Investors From Themselves | WSJ

Jason Zweig, in his 250th Intelligent Investor column for The Wall Street Journal, writes:

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance…….My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.

While I agree with Jason that investors are often their own worst enemy, I would hesitate to advise anyone to invest in under-performing stocks (anticipating reversion to the mean) or to adopt a buy-and-hold strategy. Our research shows that investing in top-performing stocks (buying momentum) delivers significant outperformance over a buy-and-hold strategy in the long-term.

The risk to momentum investing is not of reversion to the mean, but of significant draw-downs when there is a broad market down-turn. Most stocks fall in a bear market, but top-performing (momentum) stocks tend to fall further. Value stocks are also likely to fall during a market down-turn and the best defense is often to move to cash or counter-cyclical investments such as bonds.

The difficulty is to identify these broad market swings with enough certainty to confidently switch your investment allocation. Common mistakes are to continually jump in and out of the market at the slightest hint of bad news, leading to expensive whipsaws, or to get caught up in the intoxicating sentiment of a bull market, blinding you to warning signs of a reversal.

I believe investors should allocate half their time to deciding what stocks to buy/sell and the other half to identifying when to be in/out of the market. Too often I see them focusing on one half while neglecting the other — usually with disastrous consequences.

July 9, 2013

BBC News: Could one man have shortened the Vietnam War?

Malcolm Gladwell tells the story of story of Konrad Kellen, a “truly great listener”:

Everyone believed what [Leon Goure, US expert who believed the Vietcong were demoralised and about to give up] said, with one exception – Konrad Kellen. He read the same interviews and reached the exact opposite conclusion.

Years later, he would say that his rethinking began with one memorable interview with a senior Vietcong captain. He was asked very early in the interview if he thought the Vietcong could win the war, and he said no.

But pages later, he was asked if he thought that the US could win the war, and he said no.

The second answer profoundly changes the meaning of the first. He didn’t think in terms of winning or losing at all, which is a very different proposition. An enemy who is indifferent to the outcome of a battle is the most dangerous enemy of all.

Goure’s analysis is a classic case of confirmation bias: he sought evidence to support his preconceived ideas, rather than gathering and evaluating evidence objectively. This applies as much to investing as it does to war.

June 4, 2013

Are You Trying to Get Rich — Or Stay Rich? | The Big Picture

Excellent post by Barry Ritholz discusses the traps awaiting rich investors or what he calls The Fallacy of Competency Transference:

Last week, Bloomberg caused a minor stir with their story on C/NET founder Halsey Minor (How Halsey Minor Blew Tech Fortune on Way to Bankruptcy):

“How do you sell the technology company you founded for $1.8 billion and five years later file for personal bankruptcy? For Halsey Minor, it may have been a fascination with houses, hotels, horses and art.”

This tale of foolishness and excess is worth discussing, if for no other reason it is strewn with lessons for others. Not just for dot com millionaires, but for anyone else who suddenly finds themselves with much more money [than] they had the prior year. This goes for professional athletes, entrepreneurs, actors, rock stars and lottery winners. Even those kids of baby boomers who find themselves with a minor inheritance can find lessons to learn from Halsey’s follies.

The key is recognizing that your new found wealth is not an ongoing revenue stream, but more typically reflects a one time (or short term) windfall.

Why is that? Because you never know what the future holds. Post IPO stock prices can falter, athletes suffer from career ending injuries, artists may be one hit wonders. An old Yiddish proverb states “Man plans and God laughs.”

How do you plan and not tickle the funny bone of major deities? Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.

I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).

The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).

What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.

Which brings us back to Halsey Minor: Without the expertise, without putting the time in, without much more than capital, he jumped into 3 different fields he had little or no knowledge of:

1. He became an Angel Investor, pouring money into early-stage startups and incubators and other such technology investments that eventually cost him a huge chunk of capital;

2. He went on a mad shopping spree for real estate, high-end art and contemporary designer furniture, “investing” tens of millions of dollars;

3. He purchased an immense Virginia Plantation where he planned to raise racehorses;

All of these purchases were eventually unwound at a fraction of their original purchase price in order to pay off creditors.

Which leads us directly to a few rules about dealing with sudden wealth:

1. You must avoid the hubris and arrogance that often accompanies sudden wealth. (Becoming wealthier does not = acquiring more expertise);

2. Debt is a dangerous tool, especially in the hands of the naive;

3. Assets are not the same as income; wealth is not the same as cash flow; Spending is not the same as investing;

4. You best understand your own strengths and weaknesses; this includes emotional, intellectual as well as behavioral.

5. Experience teaches us that the belief “I’m rich, therefore I must be very smart” is a recipe for disaster when not backed up with actual knowledge in relevant fields.

There are many more rules we can derive from this tale of woe, but perhaps the single most important one is the importance of living within your means. This is true whether you have $500 in the bank or $500 million.

Insolvency occurs when your liabilities exceed your assets and cash flow, regardless of how many zeros are on either side of the balance sheet . . .

In investment banking the joke was: “How to make a small fortune? Start with a big one.”

I have witnessed numerous examples of this Fallacy of Competence over the years. In fact I would go so far as to say it is the single biggest factor in the destruction of capital. Just because you are a competent eye-surgeon, for example, doesn’t make you a good investor. You are likely to exhibit the same level of competence as an investor as you would if asked to perform eye-surgery in your freshman year at university.

And just because you are wealthy doesn’t make you competent. The ancient Greeks believed that hubris is followed by nemesis.

As Will Rogers said: “We are all ignorant — just on different subjects.”

June 3, 2013

Smart and Stupid Arguments for Active Management | The Reformed Broker

Are active or passive investment strategies best? Josh Brown at The Reformed Broker writes there are both smart and stupid arguments to be made for active management:

Marketocracy’s Ken Kam, who has spent a career studying and vetting active managers, touches on one of each type in an interview with Covestor the other day.

First, his smart argument, the thing about all strategies that is always true:

“My experience has taught me two important lessons. One, there is no sector or investment style that works all the time. And two: a great manager gets that way by honing his skill in a single sector or style. The combination of these two lessons is that if you want good performance over time, you can’t get it by using the same managers year after year.

My approach is to look among the managers who have proven themselves over the long term to find those whose style is performing well now. If there are a lot of proven managers who are all performing well now, then I choose managers whose styles are different from one another, to reduce the impact of any single manager’s style falling out of favor.”

This is absolutely correct, there is no strategy – be it active, passive, value, growth, long-short, arbitrage, mean reversion, trend-following, stock picking etc – that will always work in all environments. Kam gets this correct. The trouble is, most passive guys say they don’t care about this or that style being out of favor, they will wait ’til the cycle swings back around – “Forget the needle, buy the haystack” Jack Bogle exhorts us. Most active guys, on the other hand, will be the last to recognize (or admit) that their expertise is not beneficial in a particular market moment.

Kam’s other argument is of the “stupid” variety. Please understand that this is a very smart man making it, so no insult intended:

“Owning an index fund is like being a passenger on a jet on automatic pilot. Today’s automatic pilots are so good that one might argue that having a human pilot on board is an unnecessary expense. But would you be willing to fly on jet without a human pilot on board? Perhaps if the sky is clear you might consider it. But certainly not if you thought you might be flying into a storm.

I think index funds make sense for those who see clear skies ahead for the stock market. For those who see a storm coming, having a human pilot at the helm makes a lot more sense.”

Okay, I’m gonna stop you right there.

The passive investor absolutely does not see “clear skies ahead” at all times. Rather, this investor recognizes that most managers will not be able to detect and react to the thunderclouds in a timely, consistent way. In addition, many of them will be so hyperactive that every gray cloud will appear to be a hurricane, and so a lot of buying and selling (churn) will be the result – leading to higher taxes, trading costs and potential for missed opportunities.

While Josh does not take sides, professing that he is ambivalent about whether active or passive management is preferable, he says in the past five years passive has outperformed active investing.

I agree with Kam and Brown that no investment style works all the time. But I disagree that index funds out-perform in a bull market, when there are “clear skies ahead”. Active investors using momentum or trend-following strategies will comfortably out-perform the index. But, as Brown points out, most active investors fail to react to an approaching “thunderstorm” and will get caught in the ensuing bear market. Holding fast-moving stocks, they then under-perform the index, with sharp falls and severe capital draw-downs. And in the uncertainty that follows, like 2010 to 2012, active investors will also under-perform: with no strong trend there are too many false starts.

My conclusion is that active strategies out-perform in a bull market, while passive strategies are more resilient when there is no strong trend. Neither do well in a bear market, but passive strategies incur relatively less damage. Using technical indicators to identify the start and end of bull markets may seem the obvious solution, but can lead to false signals and expensive “churn”. A thorough understanding of macroeconomic indicators is essential to confirm market signals, but this can take years of study and is not for the faint-hearted. At all costs, do not try to make forecasts; even professional economists seldom get this right. Simply use the indicators to identify market risk and adjust your strategy accordingly.