Momentum Strategies With DJIA Stocks
Summary
- Momentum strategies work well with a portfolio of DJIA stocks.
- Among a number of alternative choices of "safe assets" for risk-off periods, we found that a good choice is an equal weight investment in Treasury Bond ETFs of different duration.
- During risk-on periods, the strategy invests in the top 12 stocks based on their 3-month relative strength. The allocation is adjusted monthly, on the last trading day of each month.
- Looking for a helping hand in the market? Members of Adaptive Momentum Investing get exclusive ideas and guidance to navigate any climate. Learn More »
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Momentum Strategy
In this article we apply the latest version of our dual-momentum strategy to a portfolio made up of the stocks in the Dow Jones Industrial Index. Restricting the stock universe to this selection of large, profitable and well-established companies is a safe, conservative approach.
We shall use a dual-momentum strategy with two regimes: risk-on and risk-off. During risk-on periods, the strategy reallocates equally in the twelve DOW stocks based on relative strength over the previous three months. During risk-off periods, the strategy invests all the funds in one or two Treasury bonds funds.
A topic that received much attention in this work was the choice of factors associated with the transitions between risk-on and risk-off states of the equity markets. Here is the list of funds used to generate signals for market state:
We already have used DBB as an absolute momentum asset. In that function the return of DBB is compared with the return of risk-free assets, such as Treasury Bills. In this new application the return of DBB is compared with the return of the US dollar. Therefore, the condition that must be satisfied for switching to risk-off allocation is that the return of DBB is smaller that of UUP over the relative strength evaluation period. Since the Portfolio Visualizer does not include these types of conditions, the strategy is implemented in Python.
Source Note: The idea of using the pair (DBB,UUP) as a market risk-off indicator was first published in a post by Peter Guenther and others in a Quantopian Forum thread.
Following is the list of parameter values used in simulations.
Initial Balance: $1,000
Absolute momentum period: 3 months
Relative strength period: 3 months
Assets to Hold: 12
The transition from risk-on to risk-off is made the following trading day after the condition for market-off is satisfied. The reverse transition from market-off to market-on is done after a delay of two days since the risk-on condition is detected. The allocation is updated at the end of each month during risk-on periods.
Simulation Results
The portfolio for the new strategy was simulated using custom software written in Python. DBB and UUP are used to determine the risk-off periods, while IEF and TLT are used as the safe, "out-of-market assets."
The results for simulations from 1/1/2008 to 2/25/2021 are shown in the table below.
Portfolio | Initial Balance | Final Balance | CAGR | Stdev | Max DD | Sharpe ratio |
30 DJIA | $1,000 | $12,682 | 21.33% | 14.07% | -15.14% | 1.47 |
SPY | $1,000 | $3,449 | 9.88% | 15.87% | -51.75% | 0.43 |
A graph of the portfolio balance is shown in Figure 1.
Figure 1. Equity plots of the new strategy - logarithmic scale.
Source: This chart is based on the author's computations
It can be seen that the strategy avoided the market losses during the bear markets of 2008-9 and March 2020. It performed quite well during the market corrections of August/September 2011 and October-December 2018. Overall, the performance of this new strategy with DJIA stocks is excellent and beats the market most of the time.
In the table below, we report the performance of the strategy for three different choices of safe assets during risk-off periods.
Safe Assets | Initial Balance | Final Balance | CAGR | Stdev | Max DD | Sharpe ratio |
IEF | $1,000 | $9,991 | 19.15% | 12.48% | -12.23% | 1.484 |
(IEF + TLT)/2 | $1,000 | $12,682 | 21.33% | 14.07% | -15.14% | 1.466 |
TLT | $1,000 | $15,740 | 23.42% | 16.38% | -19.25% | 1.374 |
As expected, the 7-10 year Treasury fund IEF produces lower returns with lower drawdowns and lower volatility. The 20+ Treasury fund TLT produces higher returns with higher drawdowns and higher volatility. The second row in the table shows the results for equal weight investing in IEF and TLT.
State of the Equity Markets
First, the indicator used in this article indicates that the market continues to be in risk-on state. The 3-month return of the base metals, DBB, is significantly larger than the corresponding return of the US dollar index, UUP. Similarly, the 3-month returns of XLB, SLV, XLI and XLY, are larger than the corresponding returns of UUP, GLD, XLU, and XLP.
Additionally, the US High Yield Option-Adjusted Spread declined during February from 3.84 to 3.40, an indication of expectations for healthy economic activity. The US Leading Economic Index, LEI, has increased any single month since May 2020.
Nevertheless, there are some reasons to worry about an imminent market correction. Long term interest rates have been in a steady uptrend since August 2020. That has fueled a rise in inflation expectations, a strengthening of the US dollar relative to other major currencies, and increased volatility in equity markets.
The implied volatility index VIX had a big run up this past week. VIX has been an excellent indicator of changes in market sentiment associated with bear markets and corrections. All market corrections started with big increases in market volatility. On the other hand, not all big increases in volatility have been followed by significant market corrections. While a big jump in VIX at the end of February 2020 was a timely warning of the deep market downturn that happened in March 2020, since then we had four big jumps in VIX (June 10-15, September 3-4, October 26-28, January 26-26). None of these VIX jumps was followed by a significant correction.
Another factor indicating a risk off status is the negative 3-month return of the total bond market. As of 26 February 2021, the 3-month return of BND is -2.04%, versus a return of -0.02 of the Treasury Bills, BIL.
Conclusions
Although the new strategy requires the use of custom software for backtesting, the strategy is easy to execute manually. It involves minimal monitoring and few asset reallocations. The signal for determining the state of the market is easy to compute, and it triggers changes very seldomly. As an example, the latest three signals happened on the following dates: 12/12/2019 - risk-on, 1/30/2020 -risk-off, 5/19/2020 - risk-on. During risk-on periods the assets are reallocated monthly on the last trading day of the month.
Note: Currently, the market is in risk-on. The top-12 assets for February and March, based on 3-month relative strength, are given below.
List of top 12 stocks for February:
AAPL, BA, CAT, CSCO, CVX, GS, HON, JPM, MSFT, TRV, WBA
List of top 12 stocks for March:
AXP, BA, CAT, CSCO, CVX, GS, DIS, DOW, HON, INTC, JPM, WBA.
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This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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