Investors aren’t limited to only investing in the S&P 500 and the Dow Jones Industrial Average. Every week we share the market trends we are following. We are interested in whether the trends in those markets are continuing or if they are experiencing a temporary or complete reversal.
When we identify trends, we are only concerned about the price data and what it says about any given market. We don’t need to know why a trend has formed to invest, but our human nature wants to understand what is driving them. Each week we try to offer some perspective on what we think the most substantial moves are and what critical drivers are behind them. Here we look at what is going in our globally diversified, non-correlated Crystal Bay Ubitrend strategy.
Last week’s continuing trends:
- German Equities
- Orange Juice
- Maize
- U.S. Medium-Term Bonds
- Canadian Medium-Term Bonds
Last week’s reversing trends:
- Indonesian Equities
- U.S. Equities
- Nickel
- The New Zealand Dollar
- Cocoa
What we are taking note of:
Different strategies in financial markets work at different time horizons. Starting from the longest time horizon to the shortest, we can highlight the main categories of market features or anomalies that can be exploited:
Longer than five years: Equity Risk Premium.
Over a long time horizon, stocks generate returns above bonds or cash. Every buy-and-hold stock investor takes advantage of it. These returns come with periodic 50% drawdown (about once per decade in recent history)—aye, there’s the rub.
Twelve months to five years: Valuation Mean Reversion.
Expensive stocks tend to underperform cheap stocks, but it usually takes several years to play out. There are multi-year periods when cheap stocks underperform; we’re going through one of these periods right now.
One month to twelve months: Price Momentum.
Instruments that rise in price tend to continue rising; instruments that fall in price tend to continue falling. This effect has been documented across stocks, bonds, currencies, and commodities.
Three days to one month: Stock Mean Reversion.
Unlike all other financial instruments, stocks that outperform one month tend to underperform the next month. This effect has not been observed in bonds, currencies, or commodities.
1-3 days: Intraday Momentum.
Internal market dynamics give rise to several kinds of short-term momentum. As one example, leveraged ETF providers rebalance their portfolios at the end of each day. When the market goes up during the day, they’re forced to buy at the close; when the market goes down during the day, they’re forced to sell at the close. Their buying and selling pressure creates momentum in equity indexes in the last 30 minutes of trading.
Milliseconds to Minutes:
There are a number of market microstructure dynamics that create mean reversion at the shortest time horizon, including the bid-ask bounce harvested by market-makers and high-frequency traders.
Market anomalies with horizons shorter than one month are usually not available to retail investors. They require high turnover, expensive infrastructure, and they’re limited in the amount of capital that can be deployed.
A portfolio construction process should incorporate equity risk premium, valuation, and price momentum as sources of return, in addition to income-generation from fixed income or carry strategies. There are many ways to combine them, and every investor has their unique requirements that will put different weights on them, but a portfolio that is missing one or more of these sources of returns is leaving money on the table.