The trend is your friend
On any given day, the odds of the market going up or down are not 50/50. Additionally, stock returns do not follow a normal distribution, as is commonly assumed in many models. On any given day, the market has roughly a 53 percent chance of rising. The odds of the market rising over longer periods increases continually as the time period you're looking at increases. Daily market returns are also streaky. You are statistically more likely to have multi-day winning streaks during uptrends. This plays into our hands.
A thing to remember - Total stock market returns are notoriously hard to forecast. However, volatility is relatively easy to forecast.
A award-winning paper I found is called "Leverage for the long run," and uses the 200-day moving average to forecast volatility.
The 200-day moving average method works shockingly well. We already know that 3x leveraged ETFs tend to do even better than 3x the market in low volatility markets and worse in high volatility markets. The trick to pocketing the extra return is to isolate the periods when volatility is most likely to occur.
This is an amazing split. Volatility is almost twice as high when stocks are below their 200-day moving average than when they're above it.
This indeed allows us to isolate the instances when we are most likely to experience significant market declines and the times when 3x leverage is most likely to underperform the index due to volatility drag.
By doing this, you also are able to identify environments when market crashes are more likely to occur. As you can see, over two-thirds of the worst trading days for the market occur when the S&P 500 is trading below its 200-day moving average.
The 200-day moving average isn't just something recently cooked up, either. The idea of only owning stocks above the 200-day moving average has been around for a long time. Nobel prize-winning professor Jeremy Siegel covered the strategy in his book Stocks for the Long Run but ultimately concluded that the strategy returned less than buy-and-hold, albeit with less risk.
However, the increased effect of volatility drag on leveraged ETFs (and acceleration of returns in calm markets) flips the script on this assumption.
The "Leverage for the Long Run" strategy
The moving average strategy proposed in the Pension Partners paper is pretty simple. As long as the S&P 500 is above its 200-day moving average, buy and hold UPRO. When the S&P 500 sinks below its 200-day moving average, rotate to cash.
You'd have avoided almost the entirety of the bear markets in 2000-2002 and 2007-2009 while catching the upside with 3x leverage. Valuations and growth do matter for this strategy as we can explain roughly 20 percent of the variation in future stock returns by valuation alone (typically the r-squared, a statistical measure of how much of y you can explain by x, is around 0.20), so going forward the optimal index to apply leverage to may not be the same. However, the trend following system really does work.
Academic research shows that momentum strategies tend to outperform the market at large. Adding leveraged ETFs to the momentum factor is like pouring gasoline on the fire to returns of the 200-day moving average strategy. I feel that the simplest improvement to the trend following strategy is to use the Nasdaq rather than the S&P 500, as seen by the performance over time.
The Nasdaq has outperformed the S&P 500 in roughly 60 percent of quarters going back to 1986 and has a stronger exposure to the momentum factor. You can see in the first graph above how much of a difference this has made.
Additionally, instead of investing in cash instruments when the index is below the 200-day average, I'd think about rotating into long-term Treasury bonds (TLT) to take advantage of periods of risk aversion. We know that markets tend to see most of their worst days when stocks are below their 200-day average, and also that Treasuries tend to catch a bid as investors flee risky assets in downturns. This strategy would have significantly helped your returns in 2008.
Additionally, I recommend a 1 percent band around the 200-day average to prevent being whipsawed as the market hovers near its 200-day average. Let it close 1 to 1.25 percent below before you sell and wait for it to go 1 percent above before you buy. Additionally, you may want to consider using the 150 or 175-day averages as they're less popular with traders. 200-day moving average traders are still smart money, but the fewer people you have selling when you want to sell and vice versa when you buy, the better. I'd use the moving average on the S&P even though we're trading the Nasdaq as it's a volatility forecaster, not a market timing model.
Submitted November 25, 2020 at 07:16PM by matthew-convie https://ift.tt/3m6VOxb
