On Stock Crashes, Hindsight, and Anger
“You will not be punished for your anger, you will be punished by your anger.” – Buddha
US stocks just had their worst start to a year in history last week going all the way back to 1928. The bears have come roaring back. As investors and traders frantically deal with clients and their own personal emotions, let’s put things into factual perspective.
Those that have seen my presentations, met with me or read our writings for years are aware that we quantitatively test indicators and create strategies we believe have merit. Backtesting, like any form of analysis, does not guarantee exceptional performance in the future, but it can at least provide information on anomalies or market patterns which have persisted over time.
So here’s a very simple and powerful backtested strategy. The 200 day moving average is popular as an indicator used to buy or sell stocks. Let’s make a simple rule. If a stock fund is trading above its 40 week (200 day) moving average, buy that stock fund. If below, then instead, buy Treasuries as your “risk-off” trade. For the below backtest, I used the Vanguard 500 Index (VFINX) as the stock proxy, and the Vanguard Long-Term Treasury Fund (VUSTX). Want to get more creative? Use the same rule, but leverage up the stock fund VFINX by an extra 30% to juice returns. Yellow uses that leverage, blue is the rotational risk-on/off strategy using Treasuries, orange is VFINX, and gray is VUSTX.
Looks pretty good right? Most of the time you’re trending higher, though it is worth noting that there are several flat volatile years where those who invest over a 1, 2, 3, or 4-year period are frustrated by a lack of returns and volatility/whipsaws. However, over longer periods of time and full cycles, both the unleveraged rotational strategy between stocks and Treasuries, and the leveraged one not only outperform on an absolute basis in terms of pure performance, but also do so on a risk-adjusted basis. The blue version’s cumulative return is 1,545% going back to 1986, versus the stock fund itself at 1,274%. That’s 1.2x better. The leveraged version which magnifies by 30%? Cumulative return is 2,756%, resulting in 2.16x stronger performance against VFINX as a buy and hold investment. Note that the extra 30% leverage over time significantly magnifies results. Compounding leverage can be a wonderful thing when it works over time if you have a strategy for it. It is worth noting that the 40 week MA’s strength is more about avoiding big declines rather than participating in big upside, though that upside exposure is most conducive towards using leverage. Also worth noting that if you added other momentum areas, notably emerging markets, the return path gets even more extreme.
Great! Let’s buy into that. Now instead of the chart above, you’re living performance day to day. Feel good about the rotational strategy? Well, let’s now dig a little deeper. Let’s look at the worst weeks in the strategy. Any of these percentage declines feel familiar?
Herein lies the point of this backtest and any strategy employed. It is completely and utterly impossible to avoid weeks like what happened at the start of 2016 from impacting your portfolio and creating an emotional response. In the rotational strategy outlined here, there are numerous large declines throughout history. In each and every single one of these weeks, the response by investors and traders is the same. “What the hell is going on?” “I can’t invest in this!” “You should have sold out!” “Sell! SELL!!!!!” “Change the strategy!”
Nothing can get everything right. Even if you used stop orders or decided to trade out of one of these big declines mid-week, historically it doesn’t do anything to mitigate those losses, even though one believes deeply that it would. The anger that comes from weeks like last week is no different than the emotional response that comes from other worst weeks in history in any strategy. Hindsight creates anger, but that doesn’t mean that anger is right. In the 2014 Dow Award paper on Beta Rotation, for example, we show that 80% of the time Utilities outperform the broader stock market before an extreme VIX spike. That means it also missed it 20% of the time, just like any indicator used to mitigate risk over much longer periods. That in no way shape or form invalidates the indicator.
My point here is that sometimes these things happen. Long duration Treasuries did not confirm ahead of time that last week would happen based on indicators we have tested. Following the decline last week, things do look ugly. The decline could get worse, or the market could V, or W, or L, or do anything it wants to do. Hindsight is the only way we will know after such a major break. One cannot control for the madness of sudden markets. All any of us can do is prevent that madness from impacting rational decision making.
The year is not written yet. There will come a major up move in reflation trades which would undo in the blink of an eye any damage done to portfolios so far in 2016. In the meantime, don’t let hindsight make you angry, because every strategy will have weeks in the dataset as violent as the one just experienced. That does not mean one should abandon the approach.
It is easy to forget one simple rule when it comes to investing passively or using active management. The best time to buy in is after a significant drawdown. After drawdowns is the time to rationally examine data, rather than make rash decisions failing to understand that sometimes, you just can’t avoid bad luck.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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