Market Musings 130124: Follow the Leaders

Follow the Leaders

What now after an explosive end to 2023?

November and December were excellent months for several asset classes, including stocks, bonds, gold and even listed real estate.

The main motors of this ‘everything rally’ were a combination of lower long-term interest rates (bond yields) plus abundant macro liquidity provided by central banks such as the US Federal Reserve and the People's Bank of China.

In fact November and December represented the biggest 2-month improvement in US financial conditions ever seen! 10-year bond yields declined by around 1% in the US over this period from 5% to 4%.

So while this shift in financial conditions was a boon to investors worldwide, this scale of boost to stocks is unlikely to be repeated.

Over the course of 2024, central banks in the US, Euro area and the UK should begin to cut their benchmark interest rates, as inflation rates continue to return closer to the 2% long-term target. Indeed, in the Euro area inflation rates are likely to fall below 2% sooner rather than later, given the lack of growth and relatively weak household demand, plus lower energy costs.

However, this is already anticipated by financial markets. So this then begs the question: what will propel stock market higher or lower from here?

Many stock markets have returned close to multi-year highs

While UK stocks remain out of favour in relative terms, many other stock markets around the world have rebounded to or close to multi-year highs in the last couple of months: the US S&P 500 and Nasdaq 100, the Japanese Nikkei 225, the Brazilian Bovespa, the Mexican IPC, the Euro STOXX 50 and the Italian FTSE MIB.

Employing a simple Dual Momentum asset allocation strategy

One way to decide whether or not to continue to invest in stocks now is via a mechanical strategy such as the Dual Momentum Strategy.

In its simplest form, Dual Momenum considers two types of momentum to choose which asset class to invest in, between stocks, bonds and cash:

1. Absolute momentum: has the asset gone up over a specified time period (such as 12 months) or not? Then consider

2. Relative momentum: which of two assets (eg global stocks and global bonds) has performed best over this same time period (12 months again)?

Such a simple mechanical asset allocation choice can be repeated monthly.

You may not enter at the lows or exit at the highs, but this is not the purpose of the strategy. It is rather to allow investors to easily ride long-term uptrends in stocks or bonds, but then to protect investors from losing too much in a protracted bear market where stock markets can fall up to 50% from top to bottom.

I personally prefer a shorter ‘look back time period over which to measure this absolute and relative momentum of stocks and bonds, typically 6 months. A shorter time period may be more sensitive to identify potential uptrends earlier, but has a greater risk of being ‘whipsawed’ in and out of stocks with greater costs in a sideways market without a clear up or down trend.

As of 13 January, what does Dual Momentum favour?

The steps to take are as follows:

Look at the performance of global stocks (I use here an ETF of the MSCI World stock index to represent stocks) and of global bonds (I use here an ETF of the Barclays Bloomberg world government bond index) ove the ast 6 months, i.e comparing the index level in mid July to today’s level.

Are either or both of these stock and bond indices higher today than in July?

If YES, then proceed to the next step. If NO then you should then be in cash for the next month (selling any positions from the previous month).

Global stocks and global bonds have both gone up since July

In this case, both stocks and bonds have gone u over the last 6 months.

Step 2: which of stocks and bonds have gone up the most over the last 6 months, i.e. which asset shows the best relative momentum?

The answer here is clear: stocks.

In the simplest form of the Dual Momentum strategy, you would then invest in global stocks (e.g. via buying an MSCI World index ETF) and hold it for 1 month, when you would then repeat this process.

Selecting a favoured stock market or sector

But we can go further with this trend-following approach. Rather than just buying the world stock market we can try to identify which area or sector has the strongest uptrend, again by comparing relative performance of regions over the last 6 months.

In order to be even more selective, we can add a further simple condition which is frequently used in simple trend-following systems.

We can consider only stock markets or sectors that have not only gone up over the last 6 months but which are also above their own 200-day moving averages. The 200-day moving average is a way to identify the longer-term trend of a stock or index, so being above the 200-day moving average is another positive trend signal.

US Nasdaq 100 index: Rising, higher over the last 6 months, above its 200-day moving average (in red)

Indices and sectors to consider

Aside from the Nasdaq 100 index, other indices and sectors that look attractive on this rising trend basis include the:

• Japanese Nikkei 225 index

• MSCI Latin America index (largely Brazil and Mexico)

• Italian FTSE MIB index

• SOXX Semiconductor sector

• IBB Biotech sector

• URA Uranium miners

• XLV US Heathcare

• EXV4 Europe Healthcare

• IYW US Technology

From this list, you can then perhaps select one or more to invest in for at least the next month, or for as long as the current uptrend holds in place.

My best for the week ahead,

Edmund