October 26, 2019
Welcome to another edition of the Rothman Investment Management quarterly letter. As always, this is broken into sections so you can skip around to what most interests you. The educational spotlight is a little more technical this quarter. Please let me know what you think of the contents of this letter. As we journey through life, it is always helpful to share what we are learning.
In early August I led Life Camp, an overnight Bible camp for kids. This was my twenty-third year leading this camp, and the first year that my wife, Nour was able to come with me. It has been a blessing to get to work with such a wonderful team and to see the changed lives of kids who come back year after year and then return to serve. It is a good reminder that while taking care of our financial resources is important, money does not define life. Purpose is important.
On September 28, I participated in the March for the Fallen in Fort Indiantown Gap, PA. I went with the Alpha Architect team. Alpha Architect is a quantitative fund manager led by Wes Gray, who wrote a book entitled “Quantitative Value” that was very influential for me. There were about one hundred forty people on the AA team at the event – mostly finance people, and in particular quantitative finance. We slept in the barracks at the National Guard training base before and after the hike and heard some inspiring stories of fallen warriors. Each of the twenty-eight miles on the course had a picture of a US servicemember who died in service to our country, as well as the date and location of their death. The event was moving... and exhausting. I did the march “civilian light” but those who opted to do it heavy carried a rucksack of at least thirty-five pounds. Over the course of the weekend I got to meet many great and interesting people. While resting on my bunk, I was reading a book called, “Adaptive Asset Allocation” when someone told me the authors of the book were there participating in the event. I got to meet them the next day.
Our broker, TD Ameritrade recently announced that it will be dropping commissions on equity trades (which would include ETFs) to zero, as well as cutting commissions on options trading. This was in response to discount brokers cutting their commissions to zero. While we never did a lot of trading, this will be a cost savings. There has been a long-term trend of lower commissions and lower management fees on funds for a long time. It is nice to see investors get to keep more of what their hard-earned money earns for them.
In September, we hosted a Rotary Business Social for the Rotary de Tolosa (San Luis Obispo) Club, which Hannah joined last year. Hannah created and planned a beautiful event with live music, Society Cuisine Catering, and Haute Sugar Company creating a unique dessert experience for us all. We got to enjoy our beautiful courtyard with others and have interesting conversations with wonderful people. We are blessed to be part of a great community.
Market and Valuation Update
The US economy continues to be strong, but it is showing signs of weakening. Russ Koesterich of BlackRock suggests investors need to be positioned for a slow growth environment based on economic trends1:
Economic leading indicators are somewhat weak, but not screaming recession. Consumer confidence is still strong, and small business confidence is falling, but not in a danger zone. (Data sourced from https://www.advisorperspectives.com/dshort, interpretations are my own.) Conditions can change quickly, but currently the data seem to suggest slowing growth, but no imminent recession. S&P 500 earnings growth is slowing – Factset estimates just 0.7% earnings growth on 4% revenue growth as historically high margins contract somewhat. This would require a positive fourth quarter, as Factset estimates a 4.7% decline in year over year earnings in the third quarter, which, if it comes to pass, would be three consecutive quarters of negative earnings growth.2
Valuations continue to be high. John Mauldin shared a Crestmont Research chart showing that forward stock market returns from high valuations are likely to be poor:
1 (Koesterich, 2019) 2 (Butters, 2019)
Source: Crestmont Research via John Mauldin (link)
Currently, the Crestmont P/E is in the 99th percentile. Other valuation measures also show stocks as pricey. These valuation levels for US stocks are nothing new – they have been around these levels for a few years. Exiting stocks completely now is probably not wise for most people, but exercising some caution probably makes sense. Investors who have incrementally shifted to a somewhat more conservative portfolio than their strategic allocation have still generally made acceptable returns without taking the full risk of a market correction. It is also wise to keep an eye on metrics that are indicative of short-term market returns. (See the Educational Spotlight on Momentum Investing.) In the last letter, I suggested favoring areas that are less richly valued to avoid the risk of loss if valuations revert to normal. Note that this is a long-term strategy, which would likely trail a market index while continued trends hold. For example, last quarter, the S&P 500 returned a respectable 1.8%, while the deep value Alpha Architect Quantitative Momentum fund lost 4.3%. (Source: Yahoo! Finance)
This quarter my personal improvement goal was to harness the power of focus. I tend to have too many things to do on any given day and to jump back and forth between them, nibbling on many tasks but finishing few. Finishing tasks is energizing and unfinished tasks cause a mental drain, so my approach is exhausting. Going forward, I endeavor to shorten my to-do list and finish tasks so that they are not on the list for the next day. Unfortunately, my success this past quarter was very limited, so I am carrying this forward into the fourth quarter.
Educational Spotlight – Momentum Investing: A Primer
Momentum investing is holding securities that are rising in price and avoiding or shorting securities that are declining in price. Gary Antonacci defines absolute momentum as the rise in price of a security over a defined lookback period. “Absolute momentum is a bet on the continuing serial correlation of returns, or in cowboy terms, Absolute momentum says ‘A horse is easiest to ride in the direction it’s already going.” 3 Relative momentum is similar, but it compares an investment (stock, index, etc.) against others and selects those with the strongest momentum relative to each other.
Momentum investing has had increasing academic support in recent years. Even Fama and French, the champions of Efficient Market Hypothesis, called momentum “the premier anomaly.”4 The cause of momentum’s success is uncertain. It goes against mean reversion – the phenomenon that results over time revert to their long-term averages. Wes Gray suggests that momentum investing works because investors are slow to incorporate new information such that prices move to appropriate levels over time rather than instantaneously, and that people like to buy what is popular or profitable, which keeps a trend going past fair value.5 Gray examined the timeframe of the momentum effect and found that short-term and long-term momentum (1 month and 60 months lookback formation periods) have negative forward returns, but intermediate term momentum has a positive return.6 This suggest that people tend to overreact to initial news, underreact to emerging trends and then overestimate the durability of long-term trends. Butler et al note that “one of the most powerful forces in human decision making is social influence, whereby a person’s decisions are influenced by those around them... humans will usually choose to follow the crowd rather than act against it. Momentum is simply the manifestation of this phenomenon in markets.”7
Antonacci tested absolute momentum across 8 asset classes over 39 years and found it provided a very modest bump in return and a significant improvement in volatility and in maximum drawdown.8 9 Even if we dismiss the improvement in return as insignificant and within the range of random noise in a study, the reduction in risk without giving up any return is quite compelling. Further, investors who intend to simply buy and hold must exhibit uncommon persistence to not sell near the bottom of large drawdowns. Those who capitulate after a large loss and then wait to reinvest until after a large portion of the recovery will trail their passive benchmark. While absolute momentum may not do much to help improve actual returns, by dampening risk it makes it easier to stick with the plan and realize potential returns.
3 (Antonacci, 2015), p. 85 4 (Antonacci, 2015), p.10 5 (Gray, 2016), p. 56 6 (Gray, 2016). P. 81-87 7 (Butler, Philbrick, & and Gordillo, 2016), 130 8 (Atonacci, 2014), p. 7 9 Specifically, Antonacci’s particular Absolute Momentum signal increased the average return across eight asset classes from 9.9% to 10.25%, with five out of eight improving, while decreasing volatility and maximum drawdown (peak to trough return) in all classes, with standard deviation of returns dropping on average from 16.48% to 11.66% and max drawdown from -53.53% to -21.43%. The test period was 6/74-12/12.
The challenges of absolute momentum are that it increases transaction costs and that it incurs multiple small losses or opportunity costs for each time it saves investors from a big drawdown. In normal times it appears to be a losing strategy – just like any insurance policy – but in extreme market conditions it protects investors.
While absolute momentum with a single asset class does not appear to add much return, within a portfolio it performed better. Meb Faber found that adding absolute momentum (he has a different methodology10 and uses the term “Timing Model” instead of “Absolute Momentum”) improved the annualized returns of his “Ivy Portfolio” from 9.8% to 11.6% and reduced the maximum drawdown from 36% to just 9.5%.11
Relative momentum, or cross-sectional momentum, compares investment choices and then selects the strongest performing to include in a portfolio. While absolute, or time-series momentum warns investors to avoid falling assets, relative momentum points to which are likely to do the best in the near future. Relative momentum can be applied to a list of assets to decide which ones to hold at any given time. Antonacci tested simply holding whichever was stronger between US and international stocks from 1974-2013 and found that relative momentum added significant return to buying and holding a stock index, at a similar risk profile.12 13 Brian Livingston examined nine popular portfolios and applied a relative momentum filter so that only the three strongest assets were held. Applying momentum improved all nine portfolios, adding 3.9% to 6.6% to the annualized returns of each over a forty-two year period.14
Both absolute (time-series) and relative (cross-sectional) momentum can be effective tools in portfolio management. Because absolute momentum works by protecting investors against steep losses and relative momentum helps investors capture the strongest gains, the two work well together.
Muscular Portfolios By Brian Livingston Book Review
I couldn’t dislike a book with a title like that. The book was written to promote a momentum- based asset class rotation strategy. There is good academic backing for using price trends to time asset classes or stocks. Brian Livingston shows how the strategies (there are two versions) would have done and the performance is impressive. While the muscular portfolios are the point of the book, most of the content is an overview of modern finance. Livingston is clearly not an academic or a practitioner, but he does a credible job covering a lot of ground and explaining
10 Antonacci compares an asset class’s return to the return of a short-term US treasury bill. Faber compares the current price to the moving average price. The timing of the study was different as well, with Faber examining 1973-2008. 11 (Faber, 2009), pp. 202, 205 12 (Antonacci, 2015), p. 102 13 Relative momentum returned 14.41% annualized with 16.2% standard deviation and a -53% max drawdown vs. 8.85%, 15.6% and -60% respective for the all cap world index. 14 (Livingston, 2018), pp. 83-87
concepts for non-finance professionals. He also does a lot of negative sales – arguing why individual investors should not trust anyone and why every other approach is inadequate.
The Muscular Portfolios approach makes sense, and historically would have provided both better returns and lower volatility than a traditional 60% stock, 40% bond mix. The system is very easy to implement. The portfolio is best done in a qualified retirement account due to its tax inefficiency.
• Market timing (which Livingston defines as moving between 100% cash and 100% stocks) is a fool’s errand. Cited is a Hulbert study that tracked 81 market timing newsletters and an average loss of 0.8% annualized compared to a 4.2% return for the Wilshire 5000. (p.20)
• Three megatrends that make Muscular Portfolios work – bargain brokerage makes trading economical, ETF’s allow low-cost, diversified, liquid exposure to an asset class, and the discovery of momentum as an actionable market factor. (pp. 22-25)
• Asset rotation is the practice of “gradually tilting a portfolio toward asset classes that have stronger momentum”. This allows investors to make money even when stocks are declining. It is similar to a skilled sailor tacking with the wind rather than relying on the wind blowing where he wants to go. (p. 76)
• Stocks typically move up in three stages after a bear market – a steep “bounce” phase followed by a much longer but much flatter “consolidation” phase, and ending with a steep “climax” phase. Investors who exit stocks after a correction miss the most powerful stage of the market, and investors who sell out once the market appears to become overvalued also miss out on a robust gain (though not as big as the first recovery phase.) (p. 206)
• Bid-ask spreads for most ETFs are at least 50% higher in the first hour of trading. It is better to wait until at least 10:30 ET to make a trade. Some platforms allow “window” trades where one can place a trade before the market opens and specify when the trade should be executed. (p. 249)
• The small cap premium probably doesn’t exist anymore. It has been absent since about 1980, and may have been simply a “statistical error made by data providers decades ago.” (p. 372)
• While momentum is good for choosing what to own, it is dangerous for picking stocks to short, as stocks with sharp declines sometimes have prolific bounces. (p. 382-383)
Livingston went too far in trying to vilify everything other than his one approach. There are plenty of bad actors in the financial services field, but that does not mean an informed consumer cannot find a competent and honest advisor. Livingston cherry-picks some extreme negative examples and holds these out as the norm. He also paints his portfolios in an overly positive light. A good example of this is he dismisses the idea of adding a momentum factor onto “Lazy Portfolios” saying this approach doesn’t work consistently because they are not designed for that,
but then ignores that one of the so-called “Lazy Portfolios”- the Ultimate portfolio, earned a higher return with a lower drawdown than either Muscular Portfolio. He argues that market timing using indicators is impossible, but that is exactly what his strategy is based on. (He says that price is not an indicator, but when you are comparing current price with historical prices and using the ratio to determine exposure, it is an indicator.) It is not clear whether there could be some data mining in his research. Finally, Livingston occasionally presents his opinions as facts, rather than clearly differentiating opinion from fact.
Thanks for taking the time to read my latest quarterly letter. I am happy to discuss any of the topics covered here in person. If you have topics you would like to see addressed in future letters, please let me know.
Until next time,
Works Cited Antonacci, G. (2015). Dual Momentum Investing: An Innovative Strategy for Higher Returns With Lower
Risk. New York: McGraw Hill Education.
Atonacci, G. (2014, April 10). Absolute Momentum: A Simple Rule Based Strategy and Universal Trend-
Butler, A., Philbrick, M., and Gordillo, R. (2016). Adaptive Asset Allocation. Hoboken: John Wiley and
Butters, J. (2019, October 18). Factset Earnings Insight. Retrieved from Factset:
Faber, M. (2009). The Ivy Portfolio. Hoboken: John Wiley and Sons.
Gray, W. and Vogel, Jack. (2016). Quantitative Momentum. Hoboken: John Wiley and Sons.
Koesterich, R. (2019, 10 22). Slowing Growth Demands the Right Style. Retrieved from Advisor
Perspectives: https://www.advisorperspectives.com/commentaries/2019/10/22/slowing- growth-demands-the-right- style?bt_ee=1j9XlQyLOuS0Rc315brZDNwPvAmkmqrT4BSufneFsx%2BycK%2FdPoYBD9FAMGNnK fVa&bt_ts=1571772802688
Livingston, B. (2018). Muscular Portfolios: The Investor Revolution For Superior Returns With Lower Risk.
Dallas, TX: BenBella Books.
The views expressed are the views of Jacob Rothman on behalf of Rothman Investment Management, LLC through the period ending September 30, 2019 unless otherwise specifically indicated and are subject to change at any time based on market and other conditions.
This letter is for informational purposes only and is being furnished on a confidential basis to a limited number of eligible clients and perspective clients. The information herein may not be redistributed.
All financial information in this letter is as of September 30, 2019 unless otherwise specifically indicated.
The information herein should not be considered a recommendation to purchase or sell any particular security. The securities and strategies discussed herein are meant to be examples of Rothman Investment Management investment approach but do not represent an entire portfolio or the performance of a Fund or Strategy and in aggregate may only represent only a small percentage of the portfolio holdings. It should not be assumed that any of the securities discussed herein were or will prove to be profitable, or that the investment recommendations or decisions made by Rothman Investment Management in the future will be profitable.
The benchmark for US Large Capitalization stocks is the S&P 500 Net of total returns, a market capitalization weighted index containing the 500 most widely held companies.
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