One side of the river is occupied by momentum traders. On the opposite side the strategic allocation crowd is standing. The average depth of the river is four feet.
Since I joined financial social media about 8 years ago I have noticed the struggle between the market timing and strategic allocation cults.
It is almost like the wars between those secret societies a few centuries ago.
There are no winners since there are too many assumptions on both sides. The arguments in favor of one method and against the opponent’s sometimes become trivial. Both methods rely on past to make statements about the future.
Strategic allocation example
The most frequent example of strategic allocation is the stock/bond portfolio and its many composition variants depending on investor age, risk preferences, etc. Undoubtedly, the 60/40 portfolio is the most popular one. Below is a backtest from 01/02/2004 to 09/23/2019 with annual rebalancing.
The above chart also shows a drawdown profile and a monthly returns table. The results appear surprisingly good: worst down year is 2009 with -3% return, maximum drawdown is about -19% at less than half of that -55% SPY drawdown and year-to-date return is more than 20%.
What is the problem here? The correlation of returns of this allocation with the SPY returns is more than 0.70. This is unavoidable. But the main problem is that it’s been a long time since USA economy had an environment of both falling bonds and stocks. This is the main hidden risk in this allocation: if stocks fall and yields rise, many years of earnings will be wiped out. The river is four feet on the average but for only a small distance it may be 20 feet deep. Crossing it may be fatal. {1}
Market timing example
Out of the many ways to time the markets, momentum always makes the best impression since it minimizes transaction cost and presumably provides tail risk hedge.
Below is a backtest from 01/02/2004 to 09/23/2019 of the long-only 50/200 moving average cross in SPY adjusted data.
In this case the largest annual loss is 6.5% in 2011. Maximum drawdown is about the same as with the 60/40 portfolio at -19%. However, equity curve is choppier resulting in 0.66 Sharpe ratio versus 1.04 for the strategic allocation. Obviously, this is not the Holy Grail but looks reasonable.
What is the problem in this case? It is simply the fact that in USA markets there has not been a long consolidation in recent years, as for example in Emerging Markets. Sideways chop is a killer of momentum and trend-following. This is what the majority of articles in financial blogosphere avoid to discuss. In other words, the river has some spots that are 30 feet deep. No one will cross it.
Recycling
I have seen in the last 8 years same articles being recycled about the merits of either strategic allocations or momentum. I have not seen anything new. I do not see any articles about long-short equity and related algos. I occasionally write articles on that subject but the popularity appears low. Most think that they will either allocate funds or time the market and avoid tail risk. But this is crossing a river that is 4 feet on the average.
The next bear market will induce many changes on the way people treat investments and on strategies used. For many it will be too late to adapt.
[1] N. N. Taleb in Antifragile
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