about 3 years ago • 4 mins
Following my recent Insight on dodging bubbles, I thought it’d be worth digging further into “momentum-based” strategies for timing market exits. I’ve even got my hands dirty and developed a new and improved momentum indicator. Here’s why I think it’s a good guide to knowing when the market music has stopped – and how you can apply it to any investment.
Buying things that are going up in price and selling those that are going down is called momentum investing. One of the reasons this simple approach has historically been so successful is that it relies on other investors’ deeply held behavioral biases, such as herding and extrapolation.
The idea is that if the force behind a price move is strong enough, prices are likely to continue moving in the same direction. At some point, however, the pendulum will reach an extreme, momentum will begin to shift, and market forces will push prices back the other way. If you can identify the moment when that momentum turns, then you’ll be able to get out with maximum profit.
That’s the theory, at least – so how does this all work in practice?
The momentum indicator I propose using is simple. You need only ask yourself: “is the investment’s price today higher than the price 4 months ago, 8 months ago, and 12 months ago?” If you answer “no” more than once, then momentum may well be turning – meaning it’s time to sell.
I believe this indicator is an improvement on investors’ traditional “12-month momentum” signal for three reasons. First, it doesn’t rely on a single time period; second, it’s more reactive; and third, it provides information on the stability of the trend (positive momentum across all three time horizons suggesting “smoother” progress than two).
In order to test the effectiveness of this approach, I downloaded data from the US Federal Reserve and applied my momentum indicator to the Nasdaq Composite Index at the end of every month since January 1998.
Every time my questions met with more than one “no”, I imagined exiting and sitting fully in cash for the following month. When positive, I’d remain fully (re)invested in the index. Here’s how using this indicator to exit and re-enter would have performed (ignoring fees) versus simply buying-and-holding the Nasdaq:
The results are pretty impressive: not only would you have achieved slightly higher returns overall, but you’d also have significantly reduced your losses in both the 2001 and 2008 crashes. By January 2003, you’d have outperformed the Nasdaq by 120% – and by January 2009, you’d have beaten it by a whopping 170%.
Is the indicator’s promise of higher returns and lower losses too good to be true? Well, yes and no.
No because limiting losses in large market falls is precisely why my momentum strategy outperformed buy-and-hold. In both 2000 and 2008, this simple indicator was flashing red well before the Nasdaq experienced the bulk of its losses. You’d have lost only 28% in 2000 and 16% in 2008, versus 75% and 71% with a buy-and-hold approach.
Yes because this limiting of losses comes at the cost of missing out on some returns. The indicator’s main weakness is its tendency to flash up “false positive” sell signals while markets are experiencing snappy “v-shape” (March 2021) and “w-shape” (December 2015) recoveries. In other words, don’t expect this indicator to work perfectly in all environments.
Stll, I see my momentum indicator as a pretty reliable – and cheap – form of insurance against extreme losses. Using this technique would have paid off over the last two decades – and so long as you think another 2000- or 2008-style crash is a real possibility, then using this indicator may make a lot of sense.
As things stand today, the indicator isn’t telling us to exit markets like the Nasdaq just yet. But bearing it in mind – and perhaps setting a reminder to ask yourself those three questions at the end of every month – could well be worth it.
After all, such rules-based momentum indicators are designed to both benefit from others’ emotions and avoid falling prey to your own. So go on: try challenging your prejudices by applying my approach to your favorite investment – be that bank stocks or bitcoin.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.