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I love Labor Day weekend. 

The weather starts to cool off. And I get a chance to fire up the grill with friends and family. 

And we start to forecast the final four months of the year for the market.

But this weekend was a bit different than usual. 

After last Thursday’s sharp tech downturn, the financial media pushed headline after headline about increased volatility and the potential for bigger selloffs. Panic is setting in again.

My phone kept going off with alerts from various websites with one hyperbolic headline after another.

So, it wasn’t surprising this morning when we saw a continued downturn in tech stocks. 

Those who worked themselves into a panic and sold big on Tuesday morning likely made a mistake. 

Even if it works out, most people are selling for the wrong reasons. 

Emotional decisions always make sense at first. But people will get tempted to follow their lizard brains and make bets trying to time the coming ebbs and flows of the market in the days ahead. 

That typically doesn’t work out in their favor.

Investors must know what they are going to do in reaction to a market move BEFORE it happens. 

They need a simple plan, with simple rules. 

So, let’s take a look at a very specific investment approach that can mitigate future risk and deliver solid gains in a positive market.

 

 

That typically doesn’t work out in their favor.

Investors must know what they are going to do in reaction to a market move BEFORE it happens. 

They need a simple plan, with simple rules. 

So, let’s take a look at a very specific investment approach that can mitigate future risk and deliver solid gains in a positive market. 

 

Making Money with Momentum

 

When it comes to volatile swings in the market, you have a series of choices.

Losing your shirt doesn’t have to be one of them.

Yes, you could be like Warren Buffett. He has an incredible threshold for short-term pain. 

And he argues (historically correctly) that the markets will always recover and maintain bias to the upside.

Or, you can reduce your pain by selling covered calls and collecting premiums to help offset the losses. Call premiums tend to be juiced during selloff thanks to heightened volatility so you can collect a lot of cash during big sell offs.

I tend to like this strategy when the RSI is high on a stock. But it can come back to bite you if the Federal Reserve decides to drop another gazillion dollars out of a helicopter.

 

 

If you don’t want to ride it out, you can use one of the timing signals we discussed last week to jump in and out of the market. 

But there’s one last strategy that I want to share with you. 

I think it’s important that people know there is a way to time the market. 

But you have to think with a long-term lens.

Today, I want to introduce you to something called “Dual Momentum.”

It’s a strategy developed by Professor Gary Antonacci, a highly regarded academic and investment professional. 

Antonacci found that when you combined “relative” and “absolute” momentum, good things happen. 

The combination creates an asset management strategy that avoids large losses and helps to maximize long term returns.

 

Keeping it Simple

 

The rules for dual momentum are simple. 

You select two or more asset classes and a cash option. 

 

 

Whichever asset class is performing the best over the past 12 months is the one you want to own. 

That’s relative momentum. It’s the idea that if you have one asset that is up 15% in the last 12 months, and a second that is up 30% in the last 12 months, you’ll allocate more money to the second asset.

If both asset classes have negative returns over the last 12 months, you’ll want to be in cash. 

That’s the element of absolute momentum

You’re looking at the price of the asset against its historical performance. You buy when momentum is positive, and sell when it’s negative. But in the case of negative momentum, you want to ensure that you’re sitting in cash for when an opportunity comes along.

Antonacci used U.S stock and International stocks in his research (plus the cash option). 

But you can use almost any asset class. 

You can use gold, REITs, composites, oil or whatever else strikes you fancy. You can use the S&P 500 and the NASDAQ to select which asset class you want to own in the U.S. markets.

Using the S&P and NASDAQ has been a very effective approach that has beaten the market for decades. 

More importantly you avoided the worst of the massive stock market crashes we have seen in the last 20 years. 

When absolute momentum went negative over the 12-month span, you wouldn’t have owned stocks between January 2001 to May of 2003.

During the Great Financial Crisis, you’d have been largely out of stocks from February of 2008 to July of 2009. That period is when all the carnage and volatility occurred during the GFC.

Recently, when measuring the Dow against the Nasdaq, you’d have remained invested in NASDAQ stocks. The dual momentum system had actually switched into the high growth market darling index in September of 2019. 

The NASDAQ never went negative on a trailing 12 months basis, so the system never bailed on stocks. 

Your gains were trimmed substantially by the March decline, but you’d never show a large “real” loss. 

More important, you’d have captured all of the ridiculously swift and powerful recovery. 

Just using the NASDAQ 100 Index, you have a 59% gain over the past year.

 

Balancing It Out

 

It’s not as important which method of dealing with declines you choose. 

It’s critical that you choose one that fits your style and comfort level before the selloff happens.

The worst year you would have had in the last 20 years would have been 2008 when the decline was roughly 23% while the market lost 26%. Keep in mind that this period was one of vast illiquidity issues and an unprecedented collapse in the housing market. 

You could have used just the S&P 500 and cash as your dual momentum assets to reduce the biggest loss to less than 10%. 

But it would have come at the cost of about one third of your long-term returns.

Riding it out, trend following, trailing stops, or dual momentum are all solid choices. 

The important thing is to know which one you plan to use before the selling starts and emotions take over.

We’ll talk more about volatility and how to manage your emotions later this week.

 

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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