Why Momentum is now part of my journey

Many readers may know me for my fundamental analysis background.

I like to think I was OK at it. I was head of a research process that resulted in our Quant Fund being rated as number one in the country several times. I had built and curated many quant models, which drove alpha for my clients.

I’ll be honest. As challenging and engrossing as it was, applying fundamental analysis had treated me well over the years, and coupled with the insights and power of quantitative analysis, I felt I had an edge. An edge on everyone else.

So when I decided to leave my employer in 2020 on the cusp of a series of endless consecutive lockdowns (I live in Melbourne – officially the most locked down city in the world!) and the subsequent COVID correction, suddenly, I was out on my own. I had no staff to command. My access to resources had disappeared and there I was, living off my life’s work without a regular cash flow stream.

This last point was incredibly important and an awakening. After having educated tens of thousands of retirees I finally really understood their predicament and it struck me now more clearly than ever before.

Preservation of capital is critical

I know that pullbacks in the market are normal. I also know, and believe, that they create opportunities and if harnessed correctly, create the potential for excess returns. After all, I was living proof of it.

A bit of personal history first.

When the depths of 2008-09 were formulating, I was literally living off bread and potatoes whilst looking behind every couch and in every drawer to free up as much capital as I could to put into the market. Not because I was struggling, but because I knew such large pullbacks are rare and often prove to be a once in an investing lifetime opportunity.

Of course, this mindset is much easier to adopt when you are gainfully employed or when there is a stream of inflows into your Fund which you can allocate to these value opportunities.

The “opportunity” doesn’t seem as obvious for those who are not gainfully employed and who have a large allocation to the market. Given the positive market, many retirees and those individuals without a weekly income were attracted to the market in a false belief that the market goes up all the time. They were fully exposed and most susceptible to a big and protracted pullback.

For them bread and potatoes weren’t an option, they were a necessity. The All Ordinaries Index pulled back 55% from its peak to a low of 3091.6. Many stocks, particularly more growth orientated ones, fell by even larger amounts. They were scary times indeed.

Such large capital drawdowns for those without an ongoing cash flow stream are brutal for two reasons.

1. Someone who experienced the entire 55% pullback, has to regain a total return (capital + dividends) of 122% to get back to breakeven. The good news is Markets do over time recover and so did investors after the GFC, “IF” they were able to keep their funds allocated to the market.
2. If the drawdown goes on for long enough (the GFC peak to trough lasted 16 months) you will be forced to selldown at the worst time, realising a massive loss and curbing your potential to eventually bounce back.

The last point is incredibly important. Removing capital from the playing field at the wrong time has a terrible impact on your overall dollar performance. Many incorrectly associate those that use charts as being risk tolerant. Whereas I would argue those that use charts to time their entry and exit, are actually risk averse, conscious of avoiding a potential ‘capital killer.’

Implementing stop losses should be viewed as the same as taking out insurance. Sure, the price may stop falling, and sure you may have to buy back in at a price higher than what you sold at. But I just look at this as my “insurance premium”. The premium I pay to avoid a catastrophic decline, and unlike fund managers who need to take multi-year, multi-million, dollar positions in businesses, as DIY investors we barely cause a ripple in a pond, therefore we have far more flexibility should things move against us.

To offset this disadvantage, Fund Managers will always point to ‘long-term’ performance. But it is very rare, and nigh on impossible, to find a manager who can outperform in a sideways or declining market, when they are experiencing net outflows at the same time. Unlike them, we have to drink our own bath water and are left with the consequences of poor performance. Whereas it is much easier to rebound and benefit from a recovery, if a steady stream of cash is still coming in.

Back to my journey

I am digressing.

Either way it had become patently clear to me that I would have an emerging cashflow problem if I ever were faced with another GFC event, because I was fully invested, and unlike the last time, I would not have access to a regular cash flow stream to keep dropping into the market, let alone to feed myself.

I knew what that felt like, the fear and angst in client’s eyes. Worst of all I could potentially face the pressure of having to withdraw funds at the worst possible time, which above all, is a decision I would hate to make the most.

This realisation dawned on me one month before I walked out the office door. We were on the eve of what was rapidly becoming an imminent global pandemic! And while fear and markets are a well-worn couple, what if this time was different, could I survive?

So, I re-visited all the notes and learnings of some of our nation’s great educators on the field of technical analysis. From Gary Stone, Nick Radge, Alan Hull, Frank Watkins, David Novak and Darryl Guppy. I even revisited notes I’d studied whilst completing a course delivered by the Australian Technical Association

I wanted to develop a capital protection strategy that worked for me. Just like with fundamental analysis, there is no silver bullet. No single formula works 100% of the time, or else everyone would look to sell when no one else is buying. The game is not to be right 100% of the time. Rather it is to be right more than you are wrong and preserve your capital from catastrophic loss so that you live to fight another day. This concept in Technical Analysis is often referred to a Money Management. As Nick Radge from The Chartists says,

“Money Management allows longevity. Longevity is the ability to continue to trade regardless of losing trades or a losing series of trades. It cannot be stressed enough, that if you do not employ acceptable Money Management skills, your chances of a terminal loss of capital or extreme equity volatility will occur without fail. … I intimately know that a loss represents a very tiny part of my trading capital and it would require an almost impossible amount of losing trades in a row to deplete my capital to the point where I couldn’t trade anymore.”

Therefore, I started to implement my learnings from these great mentors.

For the first time ever, I started to implement a stop loss strategy, I stated to implement money management techniques and started understanding how much risk I was willing to take for each holding.

Note from the Author: I still held a group of companies back then for their long-term outlook and I continue to hold them today.

The good news (for me) was that implementing such strategies was that during the COVID correction while I wasn’t able to protect 100% of my capital, I easily dodged the worst of the 39.2% peak-to-trough pullback. An impressive feat given that the speed of the COVID correction, while not as deep, was actually a quicker retracement than 1987.

Note from the Author: I just wish to point out that at this stage that I am still a student of the field. I continue to seek the insights from experts and combine that with the learnings from a growing list of academic papers into using momentum as part of an investment strategy. Its ability to drive portfolio performance particularly in Australia and its ease of implementation.

I am also very keen to explore how changes in a stock’s volume plays a roll in supporting price movements.

I look forward to sharing that journey with you all.

So, was it mission accomplished?

No, it wasn’t.

Putting all of what I have written aside, along with my pursuit of capital preservation, I am a firm believer that you need to be in the market more than you are out of it. Which means if you ever get out of it, you have to be ready, and have a strategy, for getting back in.

I believe that in the long-run markets go up. And despite the occasional blip, the market inevitably dusts itself off and continues to march forward once more to eventual new highs and with dividends to boot.

When peak COVID fear hit our psyche in March 2020, you couldn’t find a reputable analyst that could predict what happened next. Even I was quoted at the time as saying that after such an aggressive and rapid price pullback, the market will need time to heal. That V-shape recoveries were unlikely and that investors should prepare for a long winter (especially for us Melbournians as we became officially the most locked down city in world!)

Well, supported by government handouts, cooperative banking sector and accommodative Central Bank, plus the ability for consumer to purchase online, history tells us that any doomsday scenario was avoided. Had I listened to my own narrative, I would have missed much of the recovery. The recovery was relatively quick, and the All Ordinaries had recovered within 12 months from the bottom.

I will cut to the chase.

Rather than listen to my own qualitative biases, I looked at the chart’s behaviour to tell me what was happening. What I was trying to identify was whether price had found a level of support.

Using the chart meant blocking out all the macro noise and mental biases I had formed, and while I didn’t pick the March bottom, by the time I got back into the market significantly, there were still plenty of gains to be had.

In fact, 2020 and 2021 will go down as my two best investing years ever as an individual which was incredibly fortunate, given I had made the decision to retire back in late 2019.

But I will be honest, 2022 has been a little tougher. I am still in front, but arguable curbing my potential as I am fixated with protecting my downside. My ‘insurance’ may curb alpha, but I am fine with that.

After butting its head against resistance 3 times, we seem to be preparing for another run at all time highs that we first hit on 13th August 2021. What does that mean? How will I react? Does it make a difference?

I hope you appreciated this brief (though lengthy) recount on my motivation for employing momentum as part of my investment strategy. You, and I, will no doubt learn more as we go through this journey together.

Next week I will share my rules that I have established for looking at and interpreting Charts. Then, and more importantly, I use the great quantitative insights from Stockopedia to help me shortlist the right stocks to invest in that suit my approach.

A potentially powerful combination (if I get my contribution right).

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