Thanks for reading the tenth installment of my series on equity/fixed income momentum strategies. This article discusses the historic return profile of momentum strategies between fixed income and equity classes, and gives an overview of the reasons behind last month's relative performance and a look forward to relative returns in October.
The purpose of this 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 balanced portfolio. These are useful strategies for Seeking Alpha readers, especially those who allocate dollars to their investment plan on a subscription basis, like 401(k) 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.
The most basic momentum strategy involving the equity and fixed income markets is between the benchmark Treasury index (GOVT) and the S&P 500 (SPY). This monthly strategy switches between the two asset classes, owning the asset class that performed the best in the trailing one-month forward for the next one month.
In difficult market environments, Treasury bonds typically rise in value as a flight-to-quality instrument while risky assets like stocks sell off. In improving economic environments, the opposite is usually true as equities rally and bonds sell-off as investors reap the returns of equity ownership and Treasury bonds are negatively impacted by rising inflationary impacts. This latter example was certainly the environment witnessed from May to mid-September as improving domestic economic data caused bond market participants to wager that monetary accommodation would be unwound earlier than previously expected, leading to a sharp sell-off in bond prices.
Below is a graph of the historical performance of the S&P 500, the Barclays Capital Treasury Index, and a momentum strategy that buys the asset class that had outperformed in the trailing one month and holds that class forward for one month. In these strategies, the one-month holding period is a calendar month beginning with the first day of the month.
Over trailing 3, 5, 10, 20, and 40-year time horizons, this momentum strategy has outperformed the S&P 500 with lower volatility, producing the alpha authors and readers on this site are readily seeking. The results above should prove interesting to any Seeking Alpha reader trying to balance their allocation between stocks and bonds. Since 1973, when the Barclays Treasury index was first published, the momentum strategy has generated 61ps of average annual outperformance versus the S&P 500 while exhibiting less than two-thirds of the volatility. Below is a graph of the risk/return profile of buy-and-hold portfolios with varying mixes of stocks and bonds versus this momentum portfolio historically with data through year-end 2012.
This switching strategy would have allocated to stocks just over 55% (266/480 months) of the time from 1973 to 2012. Instead of allocating funds in a traditional 60% stocks/40% bonds balanced portfolio, allocating to the asset class that had outperformed in the trailing one month would have seen less dollars flow to equities, but cumulatively generated roughly 130bps of average annual excess returns. Using the momentum approach to allocate funds, investors would have actually put less money into stocks over that forty-year period than investors using a 60%/40% stocks/bonds split. However, the momentum approach would have produced meaningful incremental returns with lower realized volatility.
(For a mathematical look at why Treasuries were chosen as the fixed income asset class in these equity/fixed income momentum strategies, see my inaugural article on these strategies.)
Investors employing this momentum strategy would have held Treasuries in September given their relative outperformance versus the broad equity benchmark in August (S&P 500: -2.9%, Treasuries -0.49%). Despite Treasuries producing their fourth consecutive monthly loss in August, U.S. government securities still outperformed the broad stock market gauge as the S&P 500 produced its worst monthly return in fifteen months at -2.90%.
Equity markets rallied broadly in September, reversing losses in August as the Fed surprised the markets by maintaining its extraordinarily accommodative monetary policy. While Treasuries also rallied given that the Federal Reserve will continue a consistent level of purchases of these securities, their gains were outpaced by the gains in riskier assets. The stock/bond momentum strategies thusly underperformed in September, but part of the long-run success of these strategies has been that the strategy has held bonds when the equity market has produced historically bad months, which is why the strategy has produced lower return variability historically. Below is a list of the worst ten months of the S&P 500 since 1973. Notice that the momentum strategy misses most of these down months as the strategy only owned stocks in eight of the ten worst months.
In these months when the S&P 500 produced an arithmetic average return of -12.5%, the momentum strategy was scarcely down on average, producing gains in half of the months through its ownership of Treasuries. While the momentum strategy underperformed in September, this is part of the price of being out of equity markets when they are on a multi-month swoon.
Treasury Bonds/Small-Cap Domestic Stocks
The efficacy of these momentum strategies is driven by the low correlation between Treasuries and stocks as the two asset classes perform well in differing market environments. These strategies suggest that the market is slow to adjust to new information, allowing for outsized returns by following the trade that has been outperforming in short trailing periods (and maybe more importantly avoiding stocks, or risky assets generally, when markets are falling as demonstrated previously). It stands to reason that an asset class with an even lower correlation with the Treasury market historically, and higher long-run expected returns should produce a momentum strategy profile that fares even better than the aforementioned S&P 500/Treasury switching strategy. This is exactly what we find when small cap domestic stocks are incorporated.
From 1979 to 2012, investors who employed a monthly switching strategy between small-cap stocks (Russell 2000 ETF: IWM) and Treasury bonds would have cumulatively ended the period with nearly three times as much money as those who bought and held the S&P 500. Over that time period, the switching strategy between small caps would have also had slightly less variability of returns than owning the broad equity market index outright. The Treasury index and Russell 2000 had slightly negative correlation between their return profiles over this time period (r= -0.01). Readers should take note that the Treasury/small cap switching strategy is a souped-up version of the Treasury/large cap switching strategy with 450bps of incremental average annual excess returns, but 400bps of incremental annualized volatility. In my February 2013 article, "The Small Cap Stock Index For You," I demonstrated that the S&P Small-Cap 600 (IJR) is a preferable index to the Russell 2000, but use the latter index here for its longer historical track record.
This long-run outperformance of the momentum strategy did not hold in September however. Investors employing this momentum strategy would have held Treasuries in September given its relative outperformance versus Treasuries in August (Russell 2000: -3.18%, Treasuries -0.49%), but the Russell 2000 outperformed in September, producing a 6.38% return. Investors following this strategy would be invested in small cap stocks over the next one month given their relative outperformance.
Treasury Bonds/Emerging Market Stocks
If substituting small caps for the S&P 500 further enhanced the risk/return profile of the momentum strategy historically, then moving into emerging markets should further increase both risk and expected return. With data from the MSCI Emerging Market Index (replicated through EEM) from 1989-2012, an enhanced momentum strategy is exactly what substituting emerging markets has historically produced.
Emerging market stocks have been the most negatively correlated with Treasuries of the aforementioned equity asset classes (r=-0.17). EM stocks' tremendous performance in the mid-2000s, which featured annual returns of at least 22% from 2003 to 2007, handed off nicely to the Treasury outperformance during the credit crisis. In the last ten years, this switching strategy has beaten the S&P 500 by 2% per annum with similar volatility. Over the totality of the dataset, EM stocks have been a high beta function of the developed world, and this momentum strategy has generated tremendous returns rotating towards the hot market during rallies and towards the safe haven of Treasuries during bear markets.
Of course, the trailing twenty-five years have been historically strong for both emerging market stocks and U.S. Treasuries, which I believe we will look back on in future periods as a historic anomaly. It feels like that trend has already reversed in 2013 as both Treasuries and emerging market stocks have produced negative returns; however, the momentum strategy has largely avoided the underperforming emerging market stock leg.
While investors should not expect a 17% annualized return over the next twenty-five years as we have seen over the trailing twenty-five years, I believe that this switching strategy will continue to produce alpha. Even in the trailing five years as emerging market stocks produced a negative cumulative return, this momentum strategy managed a 8.1% annualized return, which would have outperformed the S&P 500 on both an absolute and risk-adjusted basis.
Emerging market stocks continue to lag domestic stocks given the emerging world's higher weight towards lagging materials and commodities stocks, heightened geopolitical risk in the Middle East, on the Korean peninsula, and in Brazil, and increasingly accommodative monetary policies of developed nations, which are weakening their respective currencies and shrinking export-driven emerging markets' competitive pricing advantage. The most oft cited emerging market index has now trailed the S&P 500 by nearly 19% over the last twelve months as exporters have been hampered by a weak European economy and concerns over a hard landing in China's depressed values. Like the other strategies, emerging market stocks underperformed Treasuries in August, which put the strategy in Treasuries in September. Emerging market stocks produced their return in September since January 2012, and the strategy would overweight these stocks in October.
For Seeking Alpha readers interested in gleaning long-term alpha through momentum, I will be updating the performance of these three trades (Treasuries/S&P 500, Treasuries/Russell 2000, Treasuries/EM Stocks) at the beginning of each month. By providing performance over the trailing one month, momentum investors can follow along with these trades in their own portfolios. September was a tough month for these strategies. All three strategies owned Treasuries, which produced positive absolute returns, but trailed the strong returns of the equity leg of the trades. However, part of the alpha inherent in these strategies is through lowered variability of returns as demonstrated in my new graph on the worst months for the S&P 500. Looking forward to October, these strategies will own equities relative to Treasuries. Please check out my aforementioned article on fixed income and equity momentum strategies.