Dow 300 Point Days and Volatility Clustering

I don’t really get Kedrosky’s post on 300 point rallies in bear markets (as a follow up to Ritholtz). The point value is not useful in comparing current conditions to past conditions. As an example, a 300 point move on the Dow now equates to about a -2.5% loss. Back in 2002 or 2003, that is closer to a -4% loss (and early 1990s that is a -10% loss, and in the 1920’s it is a -100% loss), but you get the picture.

A better question is:

Does the Dow experience its largest gains and losses in up or down markets?

As I posted previously (and the original post here), volatility is much higher and returns lower when the stock market is declining (as measured using something simple like a 200-day moving average or 10-month moving average).

But it looks like David Rosenberg of Merrill is correct, most of the big days come when the market is under the moving average. About 65% of the time (since 1929) the DJIA is above the 200 day simple moving average (this is using Yahoo data). That makes sense, markets go up a majority of the time.

However, take a look at the table below.

The following conclusions can be drawn:

1. The market returns, on average, are much higher when the market is in an up trend.

2. The market volatility, on average, is significantly higher when the market is in a down trend. (Those vol numbers anualize to about 13.8% and 23.8%, respectively.)

3. The largest moves in both directions occur when the market is in a downtrend.

Note: #3 is due to #2, a point most people miss. The bigger moves occur because the market is more volatile – namely because people are scared. Going back to this great presentation from Andrew Lo, people use different parts of their brain when the market is declining. If you see people lining up at IndyMac across the street like I did a couple weeks ago, you are probably going to be a little more irrational than when your Chinese ETF is hitting new highs.

This is the main reason my timing model works. It sits out the times when markets return less and are more volatile. Nothing earth shattering, but it does buy you peace of mind.

Harvard Endowment 2008 Results

Estimates for returns for the fiscal year ending June 30th, 2008 are around 7-9%. Pretty impressive considering stocks were down more than -10% over the same time period. Below is a table of the five main asset classes over the past year and their total returns. The buy and hold allocation is the same allocation mentioned in my paper, namely a 20% allocation to the same five asset classes. No rebalance over the time period.

Click on the table to enlarge.

One could replicate these asset classes with the following ETFs:


“Tactical Allocation in Commodity Futures Markets: Combining Momentum and Term Structure Signals” by Ana-Maria Fuertes, Joëlle Miffre and Georgios Rallis.

As usual, CXO offers up a great overview of an academic paper:

In summary, commodity futures trading strategies that combine momentum and roll return may offer strong performance largely uncorrelated with those of stocks and bonds.

How long until we see a roll return-momo managed futures ETF?

Alpha Persistence & A Simple Momentum System For Beating the Market

Alpha persistence in long short hedge funds. This study gives a lot of support to the upcoming AlphaClone software launch.

This is similar to private equity, where the top funds continue to outperform. Why doesn’t this happen in mutual funds? A couple reasons (including index hugging), but the simplest is the capitalism 101 – the $ attracts the best talent.

Now, on to momentum…


Efficient market theorists have long been puzzled by momentum, and exclaim that it should not be possible to make money from buying past winners and selling past losers in well-functioning markets. Practitioners have been ignoring these efficient market theorists and collecting money for decades. There are probably more academic pieces written on momentum than almost any other subject in finance. (Besides the efficient market hypothesis of course.) I count nearly 900 when searching momentum on the SSRN.

Which is why it makes me shake my head when people talk about how technical analysis doesn’t work. It is such an uninformed opinion it is embarrassing at this point. At least three of the Alpha Hall of fame members use technical analysis. I am not defining TA as the subjective form of “charting”, but rather the simple analysis of price. Some call it tape reading (Cohen), some call it quant analysis (Simons), and some are fine with the TA label (Jones).
(Disclaimer: Before I start getting loads of hate mail on why technical analysis doesn’t work, please realize I do not bow at the alter of any discipline, but am simple guided by what works for me and most importantly what makes money – whether it be value factors like price/book, valued-added fundamental analysis, sentiment analysis, mean reversion techniques, or systematic arb strategies I don’t care.)
Fama and French found momentum to be the most predictive of their four factors, and countless other speculators have used momentum as parts of their models. Just about every CTA out there uses momentum under the label trendfollowing.
One of the most comprehensive studies was performed by Dimson, Marsh, and Staunton of “Triumph of the Optimists” fame. They found that winners (top 20% past returns) beat losers (bottom 20%) by 10.8% per year in the UK equity market from 1956-2007. Even using the top 100 UK stocks by market cap still produced a 7% outperformance. Taking a look at these top 100 stocks since 1900, they found a 10.3% per year outperformance.
For a good overview of the momentum literature check out the appendix in the recent book Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing, as well as this listing of papers.

Momentum strategies have been in existence for the majority of the 20th Century (and probably longer). Alfred Cowles and Herbert Jones found evidence of momentum as early as the 1930s [1937]. H.M. Gartley [1945] mentions methods of relative strength stock selection in his Financial Analyst’s Journal article “Relative Velocity Statistics: Their Application to Portfolio Analysis.” Robert Levy [1968] identified his own system in “The Relative Strength Concept of Common Stock Price Forecasting”. Other literature penned by investors who suggest using momentum in stock selection include O’Shaughnessy’s [1998] book “What Works on Wall Street”, Martin Zweig’s “Winning on Wall Street”, William O’Neil’s [1988] “How to Make Money in Stocks”, and Nicolas Darvas’s [1960] “How I Made $2,000,000 in the Stock Market.”

One of the best reasons as to why momentum (and by default, indexing) works is the distribution of stock returns. I have a few charts in my book that I think are fantastic, but you will have to wait until that comes out in January.

CROSS-MARKET MOMENTUM (or, relative strength)
I published a paper about a year ago that focused on a very simple trendfollowing system to reduce risk. The paper could have easily been called “A Quant Approach to Risk Management” as it is really the same thing. However, many investors are not interested in reducing risk, but rather maximizing returns. One could simply leverage the existing system, but with retail rates for margin and cash that is not ideal and will compromise results.
Below we examine a simple cross-market momentum system that stays fully invested at all times. This system compares assets to each other (is real estate going up more than bonds?) rather than my paper which compares assets to themselves (is the S&P going up or down?).

This can also be called a rotation system as you are rotating into what is performing best over a given time period. Many people have researched such systems over fifty years ago and they have continued to work decades after publication.

The system uses the same five asset classes as before – US Stocks, Foreign Stocks, US Bonds, REITs, and Commodities.

Each month, the 3, 6, and 12 month total returns are recorded for each asset class (and then averaged for the combo). The actual time frame selected does not matter much as the 3, 6, and 12 month time frames all produce similar results. I prefer using all three (combo) because it picks the asset classes that are outperforming in numerous time frames.

The investor then simply invests in the top X asset classes for the following month. For example, at the end of 2007 the order of returns from best to worst was Commodities, Foreign Stocks, Bonds, US Stocks, and Real Estate. The portfolio for the next month (January) in 2008 would be in that same order.
Below we show the results of taking the top one, two, and three asset classes, updated monthly, based on the rolling 3,6, and 12-month total returns. (Top 1 means you just take the top asset class each month. Top 2 means you select the top two asset classes each month and put 50% of the portfolio in each, Top 3 is the top three assets with 33% in each, etc).

Click on table to enlarge.

While simply taking the top performing asset class may seem like a good idea because it experiences high returns, in reality it is not. Investing 100% of your portfolio in only one asset class leaves the investor exposed to market shocks, and consequently the turnover, volatility, and drawdowns are higher for a single asset class. A better idea would be to invest in the top 2 or 3 asset classes each month which equates to the top 40-60% of asset classes. (So, traders could run this with 10 asset classes and select the top 50%, or 5 asset classes.) A generic 10 asset class allocation is below (I offer two ETFs in each asset class in case people are utilizing tax harvesting):

US Stocks – VTI, SPY
US Stocks -VB, IWM
Foreign Stocks -VEU, EFA
Foreign Stocks -VWO, EEM
Bonds – IPE, TIP
Bonds – BND, AGG
Commodities – DBC, DJP
Commodities – GSG, RJI

For similar risk as buy and hold, taking the top 3 positions for the “combo” outperforms by over 4% per year, with a similar Sharpe Ratio as the timing model. We expect 0.80 to be a consistent target for a momentum approach to tactical asset allocation regardless of the exact strategy employed. This strategy outperforms the buy and hold portfolio about 70% of all years, and 10 of the past 15 years. Taxes are obviously a drag, so it makes the most sense to run this in a tax-defered account. For those who feel that commissions will be restrictively high, the system could be updated quarterly.
I believe that as humans are involved in the financial markets, the markets will continue to be driven by the emotions of greed and fear. This aspect of the market is a simple example of an alpha generator that is “timeless and universal”. Beta asset classes go up about 70% of the time. My research has shown that returns, on average across the five asset classes back to 1973, are about 40% lower and volatility is 20% higher when asset classes are below the 10 month moving average. This “volatility clustering” is one of the simple reasons the timing model works – when markets are declining people become more fearful and use a different part of their brain when markets are going up.
There are many, many variants and offshoots one can take the model. (For example, invest in the top 40% of asset classes and sell one when it drops out of the top 50% to reduce turnover.) For the most part, the take away is that for similar risk, a momentum model generates some excess annual returns. This is not the investing Holy Grail, but I consider this a method for a simple, timeless alpha that is rooted in human psychology.

150th Anniversary of "On the Origin of Species"

New Blog


What stock from the Russell 3000 is up the most this year? The Finish Line (FINL) at 350%.

If anyone can find the Finish Line/Nike video of Meb Keflezighi where there are girls in the crowd jumping up and down wearing “Go Meb!” t-shirts I will send you a free copy of my book.


Is it just me or does it feel like another quant equity fund is liquidating?


Darst wrote one of the best books on asset allocation (right up there with Gibson’s book), and the most recent edition is titled, “Mastering the Art of Asset Allocation“. It has something like 150 pages on correlations of asset classes (and the volatility of those correlations).

He has a new book out – The Little Book that Saves Your Assets: What the Rich Do to Stay Wealthy in Up and Down Markets that I have pre-ordered.


How many banks are going to bite the dust?


Taleb charges $60,000 more than I do to give a speech


About a third of the ETFs and ETNs are too small to exist.


What hedge fund is going to name themselves the LHC fund (nod to Soros’s Quantum Fund)?

(Error corrected – orginaly typed Omega, which is Cooperman.)


A blogger comes back?

Weekend Linkfest

From Bespoke – the second worst month for commodities ever.

If you remember from this earlier post, after an asset class takes a big dump it is usually ripe for a two month bounce after waiting for a month. I will track the performance of GSG and DBC from September 1-October 31st.

All of the below had an awful June, and a strategy would be to buy these with a two month hold.

I’ll track the performance with SPY and IWR, EFA and EEM, and IYR and RWX. Other particularly awful performers that could see a bounce are:

Financials (XLF)
Netherlands (EWN)
Sweden (EWD)
India (INP)
Infastructure (MG)
Private Equity (PSP)
Foreign Private Equity (PFP)


Maybe I should have done this with “The Ivy Portfolio” – novelist sells shares in his new book.


What does Intrade know that Gallup doesn’t?


Stockscouter likes Qualcomm too.


The top 25 documentaries of all time.


The market got you down? Feel good movie of the day, “Where the Hell is Matt (2008)?”:

WikiInvest Embedable Stock Chats

Not bad. You can click, drag, pan, and zoom all without a page refresh.

Here is one for GOOG:


Everyone is jumping in the ETF boat. PIMCO files to join the fray.


Latest from GMO:

(Free to access, but you have to register.)

“The Global Competence Crisis”
7-Year Asset Class Forecasts (still gloomy)
Quarterly Review


Some great posts over at AllAboutAlpha:

Can US retail investors fend for themselves?
Betafication of alpha
Is regulation of hedge funds a contradiction in terms?

It is too bad Meb (Keflezighi) will not be competing in the 2008 Olympics…

Silver medalist in 2004.

(Picture from an old cover of RunnersWorld)

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