Equity Momentum - May 2013

|
 |  Includes: BRK.A, BRK.B, EEM, SPHB, SPLV, SPY
by: Ploutos

Near the beginning of each month, I am authoring articles updating the performance of monthly momentum strategies across a host of asset classes with this being the fifth monthly installment. Yesterday, I published articles on fixed income and equity/fixed income momentum strategies. This is the third article in this series to be updated at the beginning of each month, and will be focused on momentum strategies within the equity universe. For the second consecutive month, both equity momentum strategies correctly identified the leg of the trade that outperformed as detailed later in this article.

The purpose of this new series of articles is to demonstrate the success of these strategies, and give Seeking Alpha readers with differing risk tolerances tips on how to employ these strategies themselves to improve the performance of their respective portfolio. These are useful strategies for Seeking Alpha readers, especially those who allocate dollars to their investment plan on a subscription basis like 401k investors making automatic payroll deductions. These switching strategies can be used to adjust periodic allocations to capture the momentum effect and improve portfolio returns, especially in tax-deferred accounts. Even if readers are uninterested in implementing a momentum strategy in their own portfolio, given the long and successful track record of these strategies, these articles can still help Seeking Alpha readers time short-term tactical asset allocation decisions.

Low Volatility Stocks/High Beta Stocks

In my mid-January article "Doubling the Return of the S&P 500 Over Twenty Years," I demonstrated that a quarterly switching strategy between low volatility stocks, as represented by the S&P 500 Low Volatility Index (NYSEARCA:SPLV), and high beta stocks, as represented by the S&P 500 High Beta Index (NYSEARCA:SPHB), generated a cumulative total return more than double that of the S&P 500 (NYSEARCA:SPY) since 1990 with a risk profile equivalent to that of Berkshire Hathaway (BRK.A, BRK.B). In this series, I am updating a monthly switching strategy that will effectively own the highest or lowest volatility equities in the S&P 500 based on which segment of the market had outperformed in the trailing month.

A monthly switching strategy between low volatility and high beta stocks, which buys the leg that outperformed over the trailing one month and holds that leg forward for one month, has produced the return profile seen below since 1990:

(click to enlarge)Click to enlarge

(click to enlarge)Click to enlarge

Despite the broad market rally year-to-date, the High Beta Index has actually lagged Low Volatility stocks through the end of April (LV: 17.5%; HB 9.1%). In March, the Low Volatility Index outperformed High Beta stocks by 171bps (4.87% vs. 3.16%), which using our momentum strategy, presaged further outperformance by low volatility stocks in April. High beta stocks have now underperformed the S&P 500 for three consecutive months.

I am of the opinion that low volatility stocks should be a part of investors' longer-term strategic asset allocation given that class of stocks' historical higher average returns and lower variability of returns. My ode to Low Volatility Investing was penned in the January article "Making Buffett's Alpha Your Own," which called for leveraging low volatility stocks to generate alpha given their historical outperformance on both an absolute and risk-adjusted basis versus the market at large.

If an allocation to low volatility stocks should be part of your strategic asset allocation, then an allocation to high beta stocks must be done tactically with a short-term focus given that class of stocks' lower long run average returns and higher variability of returns. This view is borne out of the data above. Over one, three, five, ten, and twenty year trailing periods, low volatility stocks have outperformed high beta stocks on both an absolute and risk-adjusted basis. However, a temporary allocation to the High Beta Index in sharply rising markets can further boost performance as seen by the outperformance of the momentum strategy.

Over the last twelve months, the momentum strategy that switches between High Beta and Low Volatility stocks has nearly doubled the return of the S&P 500 (29.8% vs. 16.9%) while posting similar volatility. Over the past ten years, the strategy has produced an annual return of nearly 14%, which would rank the strategy amongst the top actively managed funds in the United States. Understanding the historical performance of this trade can help Seeking Alpha readers time their entry into riskier parts of the domestic large cap equity universe.

(click to enlarge)Click to enlarge

(click to enlarge)Click to enlarge

After the MSCI Emerging Market Index trailed the S&P 500 in each of the first three months of the year, the underperformance of stocks in the emerging world in April made it four straight. The outperformance of domestic stocks in April dictates that this momentum strategy will continue to own the S&P 500 in May as well. This losing streak by emerging market stocks ties the March - June 2012 swoon as the longest streak since the height of the financial crisis in late 2008.

I believe that emerging market stocks (EEM replicates the benchmark used) will outperform the developed world over the intermediate to long term as higher economic growth rates and less constrained government balance sheets lead to higher asset returns. Over the last twelve months, domestic equities have strongly outperformed emerging market equities as accommodative monetary policy in the developed world has encouraged investors to move out the risk curve and also weakened DM currencies through lower interest rates, improving relative performance versus emerging market exporters. Perhaps this momentum strategy can key when to make a longer-term asset allocation shift to emerging market equities with higher expected long-run returns.

It should be noted that in all of the time horizons in the table above, the momentum strategy has outperformed the emerging market stock index on both an absolute and risk-adjusted basis. If emerging market stocks are a part of your asset allocation mix, then understanding this trade can help improve portfolio performance.

Summary

High quality domestic stocks continue to be the predominant source of excess returns in global equity markets. This article suggests that low volatility equities will outperform higher beta equities and domestic stocks will continue to outperform EM stocks again in May just as they did in both March and April.

Switching strategies that tactically overweight high beta equities when markets are rising and seek safety in lower beta equities when markets are falling have traditionally produced higher risk-adjusted returns over long time intervals. I will be updating these two trades monthly, along with my companion series on fixed income and equity/fixed income momentum strategies. Expect to see a few additional equity momentum strategies evolve in this series over time, and as always input from my strong readership can help improve this content as we "Seek Alpha" together.

Disclosure: I am long SPY, SPLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.