How I Learned Not To Worry Whether We Are In A Bear Market And Why You Should Not Either

by: Jozef Rudy

Summary

To beat inflation you need to invest some proportion of the savings in stock market. The younger you are, the bigger proportion.

Not all people can bear 50%+ drawdowns (be it passive buy-and-hold investors or value investors).

Simple momentum filter can help us avoid biggest drawdowns and obtain return similar to market.

October was a strong turnaround month, when the first half was frightening for investors. The intra-month drop for S&P 500 Index from the last September price to minimum in October was almost -8%. Such an increase in volatility during very short time might signal that a turnaround point to a bear market is getting closer.

What should you do as a long-term stock investor? Proponents of buy-and-hold and also the most orthodox value investors would argue you should not be bothered. Value investing certainly is able to beat the market index in the long term. However, what happens often is that many investors attracted by value investing hop in during the bull market and in the middle of -50% correction lose their nerve. At this time the newspapers are full of apocalypse articles such as the crash of the entire banking system being probable in 2008. People are always alluded to thinking "this time is different" as Reinhart (2011) shows. This time the crash of the entire system is possible so I will rather save remaining 50% of my net worth invested in stock market than risk a possibility of losing most of it. When the future is the bleakest, the stock market tends to turn around (stock market leads real economy by about half a year).

What can you do, if you understand that in order to beat inflation, you need to invest in the stock market? But ideally, you do not want to test your nerve.

Though it may seem counterintuitive from the traditional asset pricing perspective, momentum anomaly is one of the strongest and most durable inefficiencies in stock markets. It has been documented to exist in equity markets since 1801, see Geczy (2013).

Thus, we can use the most frequently used form of momentum filter: 10-month moving average. Just by using this simple rule: hold our selected value stock whenever its price is above 10-month moving average, we are able to decrease the drawdowns of a value portfolio significantly.

Let's have a look at the situation graphically. The following picture illustrates the stock picking strategy - simulated on QUANTPICKER website, without any momentum filter.

As we can see, the return obtained since 1990 until present is many times higher than simple buy-and-hold S&P 500, confirming the validity of value approach to stock picking. However, the drawdowns in 2008 are +50%, similar to S&P 500 Index.

Next, let's have a look at the same strategy, but introduce the moving average filter.

We obtain return which is still higher than the return of S&P 500 Index, but with significantly lower drawdowns (actually -19% - 52% on a monthly resolution).

Thus, with a monthly rebalancing the investor would be able to obtain a benefit of market return, with much lower risk. The QUANTPICKER website allows you to do just that - shadow trade their recommended portfolio, based on the factor you choose (be it value, momentum, low volatility or any other from the anomalies listed).

It would be extremely time consuming for a person who is not in the asset management industry to replicate the process himself. Just obtaining quality fundamental data is expensive (and very time consuming).

For completeness, I attach the table with the stocks selected at the end of October.

  Ticker Universe Industry Percentage in Portfolio
AES Corp/VA AES S&P 500 Index Utilities 0.000000
AT&T Inc T S&P 500 Index Communications 0.057817
Apple Inc AAPL S&P 500 Index Technology 0.038845
Bed Bath & Beyond Inc BBBY S&P 500 Index Consumer, Cyclical 0.026702
Best Buy Co Inc BBY S&P 500 Index Consumer, Cyclical 0.015043
CF Industries Holdings Inc CF S&P 500 Index Basic Materials 0.042733
Deere & Co DE S&P 500 Index Industrial 0.000000
Eastman Chemical Co EMN S&P 500 Index Basic Materials 0.000000
H&R Block Inc HRB S&P 500 Index Consumer, Non-cyclical 0.036863
Harris Corp HRS S&P 500 Index Communications 0.000000
Helmerich & Payne Inc HP S&P 500 Index Energy 0.000000
Hewlett-Packard Co HPQ S&P 500 Index Technology 0.055608
Humana Inc HUM S&P 500 Index Consumer, Non-cyclical 0.029917
Joy Global Inc JOY S&P 500 Index Industrial 0.000000
LyondellBasell Industries NV LYB S&P 500 Index Basic Materials 0.000000
Marathon Oil Corp MRO S&P 500 Index Energy 0.000000
NVIDIA Corp NVDA S&P 500 Index Technology 0.031169
Northrop Grumman Corp NOC S&P 500 Index Industrial 0.098281
Pinnacle West Capital Corp PNW S&P 500 Index Utilities 0.042819
Public Service Enterprise Group Inc PEG S&P 500 Index Utilities 0.031898
Staples Inc SPLS S&P 500 Index Consumer, Cyclical 0.024429
Valero Energy Corp VLO S&P 500 Index Energy 0.000000
Verizon Communications Inc VZ S&P 500 Index Communications 0.083380
WellPoint Inc WLP S&P 500 Index Consumer, Non-cyclical 0.048936

Articles cited:

Reinhart, Rogoff (2011): "This Time Is Different: Eight Centuries of Financial Folly", available at www.amazon.com/This-Time-Different-Centu...

Geczy, Samonov (2013): "2012 years of Price Momentum", available at papers.ssrn.com/sol3/papers.cfm?abstract...

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.