I tested a popular contrarian trading strategy in blog #50 using Shiller’s PE ratio and found it wanting. The flip side of contrarian is momentum trading, which involves buying stocks after they have risen and selling stocks after they have fallen. So, momentum is about “going with the flow”, instead of against it. Since the contrarian strategy doesn’t seem to deliver the goods, you may wonder whether momentum trading will do the trick. This blog will attempt to answer this question with data.

As before, my data is from Robert Shiller’s website and consists of (a) the price levels of the S&P 500 index from Jan 1881 through Dec 2017 and (b) the index’s cyclical-adjusted PE ratio (CAPE) computed from its constituent stocks.

I will present two versions of the momentum strategy: a basic version and a ‘crash proof’ version. I will call these versions, MOM1 and MOM2 respectively.

MOM1 works as follows: starting with a capital of \$1, I buy the index if the CAPE in each of the previous twelve months is above 15  (call this trading signal CAPE >15). Otherwise, I do nothing. If the index is bought, it is held until a sell signal emerges i.e., when CAPE < 15. To keep things simple, I assume that trading cost is zero and that cash earns nothing. I repeat this strategy each month to the end of the sample period (Dec 2017). I then compute the terminal value (TV) by compounding the monthly returns and compare it with the terminal value of the buy-and-hold (BH) strategy. The strategy with the higher TV is the winning strategy.

The performance of MOM1 is shown in the first line of the table below.

MOM1’s terminal value is shockingly low – just \$2.58, compared with \$430.43 for the buy-and-hold strategy. In fact, it is worse than the contrarian strategy discussed in blog #50. The BH strategy is always invested, while MOM1 is out of the market about 56% of the time. This can be seen from the following graph where “1” indicates being is in the market and “0” indicates being out of the market. The high outage of MOM1 is what causes its terminal value to be so embarrasingly low.

Can we salvage the momentum strategy by tweaking it? The answer of course, you can!  After all, all trading rules are arbitrary. As a researcher, I am trained to be skeptical of data mining as this is called. Data mining is useless in data where there are no repeatable patterns to aid predictions, as is the case with stock prices which behave close to random walks. Nevertheless, to satisfy skeptics, I will relent and subject another version of the momentum strategy to the test. I will call this version, MOM2.

MOM2 works like MOM1 except that it suspends buy trades following major stock market crashes. MOM2 draws on behavioral finance research. This research shows that investors tend to freak out after a big drop in stock prices. Daniel Kahneman (of Thinking Fast and Slow fame) calls this fear, loss aversion. The bigger the drop, the more it sticks in the mind, and the more loss-averse investors become. Hence, MOM2 stops buying after major crashes even if the trading signal screams ‘buy’.

It is tedious to split hairs over the definition of a crash. So, in the interest of simplicity, I suspended buy trades in just three crashes in the sample period. They are: the October 1929 crash which led to the Great Depression, the Internet bubble crash in 2001 and most recently, the 2008 crash triggered by the US sub-prime crisis. For each of these crashes, no buy trades were allowed until the S&P 500 index regained its pre-crash level. After that, trading follows MOM1.

As expected, MOM2 improves on MOM1 (see second row of table above). Alas, this is small comfort as MOM2’s terminal value of \$4.59 is barely one-tenth that of the buy-and-hold strategy!

The above results come as a surprise to me, as I am sure it is to you.  But they seem robust. They are also in agreement with other evidence presented earlier, notably the tendency for investors to chase ‘hot’ markets to their detriment (see blog #46). So, unless your brilliance leads you to the discovery of a wonder trading rule, “neither a contrarian nor momentum trader be” seems to be a sensible (if boring) strategy to follow in your quest for investment wealth.