In my last post I tested two long-term strategies from Mark Boucher’s “The Hedge Fund Edge” that were based on measuring the attractiveness of bond yields in order to trade the S&P 500. In this post, I want to offer an alternative (and more effective) short-term trading strategy that exploits this same idea.
The premise of this strategy is that stocks and bonds are always in competition for investors. As bond yields become more attractive, investors move away from stocks and into bonds, which is of course, bearish for stocks.
The graph below shows the S&P 500 (blue), the following strategy (green), and for comparison’s sake, the inverse of the strategy (red) from 1962:
(logarithmically-scaled)
Strategy Rules: Go long the S&P 500 at today’s close if the 5-day exponential moving average (EMA) of 10-year treasury yields is falling. Close the position and move to money market when the EMA is rising. This test is frictionless, and to compare it accurately to Boucher’s strategies, I’ve assumed money market returns equal to half of the nearest 3-month US Treasury bill.
In a nutshell, the strategy is bullish on stocks when treasury yields are falling relative to very recent history, and neutral/bearish when yields are rising.
The strategy did a good job outperforming the market in all periods with the exception of the late 90’s and mid 2000’s when, one could argue based on the subsequent bear markets that, equities became overinflated relative to treasuries. Drawdowns in all periods were managed well.
For the number-lovers, below are stats for this strategy relative to both the S&P 500 and strategy #1 from my previous post:
CLOSING THOUGHTS
A lot of improvements could be made to this strategy (think 5-day EMA relative to a longer-term EMA, measuring the EMA’s ROC, etc.) but I think I can say that this shorter-term strategy as it looks now is “better” than the longer-term version - and not just because of its historical performance.
In my opinion, short-term strategies (when trading assets that minimize/negate transaction costs, such as leveraged funds), are better than long-term ones because: (a) there are more historical trades to study, reducing the degree of curve-fitting, and increasing the probability the strategy will work in real-time, (b) it’s much easier to determine if a short-term trading strategy has stopped working – reviewing the results of say ten real-time trades would take about 2 months for the short-term strategy, but about 16 months for the long-term version, and (c) I’ve found that long-term market inefficiencies are much more unstable and likely to be consumed by the market.
Regardless of your opinion on the above, I think we can agree that strong treasury yields have been bad medicine for equities, even in very short timeframes.
