The Three Dials Deep Dive series is designed to help clients and the general public to understand our investment methodology. Over the past several months, we have been exploring each of our Firm’s Three Dials, which serve as the backbone of our proprietary portfolio construction model, with the aim of providing clarity on why these dials matter and how we interpret them to arrive at our asset allocation decisions. If you missed parts I & II, we hope you’ll go back and read our posts about the Valuation dial and the Economic Fundamentals dial. Today, we are delving into our Momentum dial.
AN OBJECT IN MOTION...
Let’s start today’s discussion with a flashback to our high school physics classroom. Don’t worry, you won’t be quizzed on the formula for momentum (though you’ll surely recall that momentum is the product of mass x velocity, or p = mv). Instead, let’s go back to the basics with Newton’s First Law of Motion, which is commonly stated as:
An object in motion remains in motion with the same speed and in the same direction unless acted upon by an external force.
Newton’s First Law will always be seared into my brain in the form of a childhood memory of my brother riding a bicycle down a hill near my grandmother’s house. The exhilaration of riding freely down a steep Kentucky hillside was unknown to us children who grew up in the unending flatness of Houston. As long as that hillside continued to slope downward, both bicycle and passenger continued on at a constant (albeit dangerously high) speed and direction. However, an unanticipated external force, in the form of a concrete curb, waited at the bottom of that hill. We all know how this story ends: the bicycle stops abruptly with the external force of the curb, but the rider encounters no such external force with the bicycle and continues to fly through the air until meeting an external force of his own: the pavement.
As it so happens, the stock market tends to follow some of the same laws as our physical universe. Allow me to restate Newton’s First Law of Motion as Archetype’s First Law of Investing:
A market in motion remains in motion in the same general direction unless acted upon by an external force.
INVESTMENT MARKETS
Of course, this is a vast oversimplification of how investment markets move. In reality, no one “external force” exists that changes the general direction of the market. Instead, the stock market represents an aggregation of every available fact or opinion that influences asset prices, including but certainly not limited to economic outlook, interest rates, valuation, corporate profitability, geopolitics, and even the weather. Market participants are constantly evaluating these variables to derive the current price of an asset or index. Historically, markets tend to move in the same direction for extended periods of time until the balance of external forces changes, like for example when an upward trending market built on the back of positive economic growth and strong corporate profitability devolves into a bear market during an economic recession.
Fortunately for the investing public, the history of stock markets is one defined by sustained periods of upward growth thanks to the wealth creation of free market capitalism, interspersed with short periods of declines during times of economic turmoil. Research suggests that, dating back to 1926, the average Bull Market period has lasted 6.6 years, with interim Bear Markets lasting just 1.3 years. This is the basic premise of momentum in investing: the stock market tends to be upward trending until it is not, at which time markets experience relatively brief but significant declines until the upward trend resumes. Famous examples of “external forces” that were strong enough to turn the momentum of an upward trending market include The Great Depression in 1929, the bursting of the Dot Com Bubble in 2000, and the Global Financial Crisis of 2008.
SIMPLE MOVING AVERAGE
A rational investor would desire to participate in as much upside as possible during an upward trending market, while avoiding the pain of a downturn when market momentum shifts from positive to negative. Unfortunately, markets do not simply come out and tell us that the balance of external forces has shifted and momentum has changed direction. Scholars and investors through the years have attempted to develop a tool to measure a change in momentum, and one popular solution has come in the form of the 200-Day Simple Moving Average (SMA). The SMA of an asset or index is measured by taking the arithmetic mean of the previous 200 days’ closing prices. One can then compare the current price to that of its SMA to determine the trend. A current price above that of its SMA suggests that the price pattern is upward trending, whereas a current price below the SMA indicates a downward trend. When an asset or index price crosses its 200-Day SMA line, one can suggest that a change in momentum has taken place.
We certainly do not mean to suggest that the 200-Day SMA is a perfect predictor of market crashes and/or upturns; indeed, no such market timing mechanism exists. In volatile markets, a crossing of the price over its 200-Day SMA is more often noise that should be ignored rather than a valuable trading signal, which is why we would not recommend trading based on an SMA indicator alone. However, our research has shown that, in conjunction with corroborating evidence, the 200-Day SMA as a representation of shifting momentum can be useful in confirming a change in market polarity and is thus a key component in our asset allocation decision-making framework.
Sources:
[1] https://www.physicsclassroom.com/class/newtlaws/Lesson-1/Newton-s-First-Law
[2] https://www.ftportfolios.com/Common/ContentFileLoader.aspx?ContentGUID=4ecfa978-d0bb-4924-92c8-628ff9bfe12d
[3] https://doi.org/10.2307/2329816
