Developments in Cryptocurrency

As many speculators keeping an eye on the space know, cryptocurrencies as a whole got absolutely hammered in 2018. This event was quite predictable given the mania that occurred in 2017 and early 2018. Everyone who asked me about cryptos at that time got a firm answer, "Stay away!"

Electronic tokens trading at valuations of billions of dollars when no-one even knows what to do with them is crazy! Sure, sending money around the world quickly and at a low cost is fantastic, but anyone with an ounce of honesty knew they weren't buying cryptos for that.

What Happened in 2018?

A lot of people who jumped into the space to buy Bitcoin and other "alt-coins" in 2017 have learned a hard lesson in speculation. Many have lost 80 to 90 percent of their money last year. Others got ripped off by exchange hacks, poor security, and scammers or lost access to their wallets.

However, 2018 was actually a great year in the blockchain world as far as the technology goes. This past year we are seeing better development of smart contracts, higher transaction capacity within the various protocols, increased efficiency, and some interesting end-user emerging projects.

For example, artists may soon be able to load their creative work on blockchain platforms and receive micropayments for each "listen" or "view" directly from their consumer. Code can be embedded into the work to prevent loss of revenue from things like torrent uploads.

Websites and blogs could attach micropayments to articles so readers can show appreciation for the work done by the authors. While many would shy away from a $10 monthly subscription (a general minimum amount required to make a credit card transaction viable), paying something like 1/10th of a penny to read an article might be acceptable.

There are also some very interesting advancements using blockchain contracts for betting. One project, Augur, is establishing an open-source market for bets. While not yet fully active, the idea is that users will be able to freely design bets of all kinds and settle in cryptocurrencies in a peer-to-peer format.

Beyond gambling on horseracing or election wins, Augur could theoretically host bets that work like options contracts or futures contracts in financial markets. It would completely bypass the exchanges, drastically reduce fees, and eliminate third-party risks as we saw with MF Global and some of the FOREX brokers.

One of the most exciting changes is the continued development of transaction processing and verification. As you might know with Bitcoin, the proof-of-work ("mining") model is very energy intensive. It also limits the number of transactions the system can handle to less than 10 per second.

Cardano, TRON, IOTA, and a few other projects are basing their verification and transaction handling process on proof-of-stake protocols. They claim this will allow great decentralization, be highly secure, and the blockchain will be able to handle hundreds of transactions per second with a roadmap to increase this to thousands of transactions per second.

The second largest blockchain platform, Ethereum, is said to be moving to a proof-of-stake protocol as well in the coming year so they can increase their transaction capacity and reduce the energy intensive "mining" process.

These developments are showing a use case for blockchain and cryptocurrencies that can be understood by the broader public. The blockchain is becoming more user friendly and it's only a matter of time before average Internet users will be able to use the blockchain for a wide variety of tasks.

It could be compared in many ways to the Internet: developing from a technical network used by universities and defense contractors to today's user friendly tools like Google, WordPress, and Interactive Brokers.

I suspect we might be at the beginning stages of a very exciting time in the blockchain world. If even a fraction of the blockchain ideas proceed, it will be a major disrupter to today's giant "middlemen" corporations: banks, exchanges, lawyers, payment processing companies, data management companies, and so on.

Speculating in Blockchain/Cryptocurrencies

From a technical trading perspective, a number of cryptocurrencies are beginning to look much more attractive. I'm particularly interested in the cryptos which are making large strides in technology—often called the 3rd generation blockchain.

Ethereum

Source: Yahoo Finance

While technically still a second generation blockchain project, Ethereum started the idea of smart contracts and has an active developer community working on moving the blockchain into the third generation to compete with Cardano and TRON.

After bumping up against the 10-week simple moving average for most of 2018, Ethereum solidly crossed over and has been climbing upwards for the past three weeks. The crypto also hit long-term oversold conditions in December 2018.

Cardano

Source: Yahoo Finance

Cardano is solidly a third generation blockchain with ample academic research behind it. The developers are working hard perfecting proof-of-stake models and are making significant progress in other areas of the protocol as well.

This is a newer blockchain that is still in early stages of development. However, it is also one of the most interesting projects in the entire space. If even a portion of their objectives are achieved, Cardano could be a blockchain platform that is a true game changer.

Cardano features a similar technical picture as Ethereum. The last several weeks have seen a turnaround that could be very promising for speculators.

TRON

Source: Yahoo Finance

TRON was formerly a token issued under the Ethereum blockchain. A migration to an independent third generation blockchain took place in June 2018. TRON has focused their efforts on the entertainment industry.

TRON is a Chinese-based blockchain group with many developers who formerly worked at companies like Tencent, Baidu, and Alibaba. The team seems highly centered around the CEO Justin Sun. TRON does state it is a fully decentralized blockchain which is a not-for-profit.

Summary

While still highly speculative and risky for any individual investor, cryptocurrencies seem to have finally shaken off the mania of the past several years. Interesting things are happening in this space.

Using simple trend indicators, some of the better cryptocurrencies are making a shift from a long, solid downtrend to a potentially promising uptrend. This could be a good time to take a closer look at some of these currencies and add a tiny amount to your portfolio.

I think it's still fair to say that many of these blockchain projects will fail and their associated currencies will be worthless. Proper risk management is absolutely crucial in this space as it is in all investing applications.

Some of the most interesting blockchain projects in my view are Cardano, TRON, and Ethereum. As these projects continue to develop their capacity and end-user tools, their adoption could become much more widespread. That can only mean one thing for their associated currency valuations.

Comments & Questions

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Dual Momentum: Relative or Absolute Momentum First?

When Gary Antonacci first shared the Dual Momentum strategy, he outlined a specific process that DIY investors could follow to narrow their investment of choice using absolute momentum (time-series momentum) and relative momentum (cross-sectional momentum).

Both forms of momentum are demonstrated by ample academic research as generating better risk-adjusted returns compared to simply holding the underlying security in all market conditions.

Gary was the first person to publicly share the outsized returns an investor can achieve by combining the two forms of momentum using major asset classes. He called this investment strategy "Dual Momentum" and it has become very popular among self-directed investors.

Dual Momentum is noted for its simplicity. The strategy only uses three broad asset classes: U.S. Stocks, International Stocks, and Bonds. The investor uses a 12-month lookback period to find the recent returns of each asset class and then follows a simple process to get the "Dual Momentum signal" for the next month.

Gary Antonacci's Process

As you can see, the process is simple and covers both forms of momentum: absolute momentum and relative momentum. Gary tests for absolute momentum on U.S. stocks first in his process. This means an investor would neither be invested in U.S. nor International stocks if the U.S. equity market was underperforming Treasury bills.

While this model is simple to follow, my first thought as an investor based outside of the U.S. was: why test absolute momentum on U.S. stocks first? What if the rest of the world is performing well while U.S. stocks are experiencing a correction?

By testing absolute momentum on U.S. stocks first, we open ourselves up to single market risk. There is a real possibility of being invested in U.S. bonds while global stocks and global currencies were doing well. This would compound the downside from a global purchasing power standpoint.

In his book, Gary shares that U.S. stocks lead markets. Based on this thesis, an investor could test for absolute momentum on U.S. stocks first as a type of leading indicator on all equities. While this argument has certainly held true for most of the past century, I'm not so sure it will persist.

In the 1900s, we saw a major shift to a U.S.-based global economy. The U.S. economy dominated the world and global currencies were almost exclusively pegged against the dollar (via gold standard or trust in U.S. institutions). In fact, during the second World War this arrangement was formally adopted via Bretton Woods.

However, in recent decades other economies have increased their influence substantially. The People's Bank of China, the European Central Bank, and to a lesser extent the Bank of Japan carry a lot of weight. We are entering a period where the U.S. is slowly receding in relative economic dominance. This could hurt investors who rely solely on U.S. stocks to drive portfolio returns.

Considering the Dual Momentum model provides global diversification, I could understand a case for testing absolute momentum first if the test was applied to the global stock universe. We could evaluate the absolute momentum of the MSCI ACWI Index to determine if we should invest in stocks or bonds.

If the absolute momentum test determined global stocks were outperforming cash, we could run a relative momentum test to determine if we should invest in U.S. stocks or International stocks. In large part the relative momentum gains realized by the investor are driven by currency changes. U.S. stocks tend to outperform when the U.S. dollar is doing well against other global currencies; International stocks do well for U.S. investors when global currencies are outperforming the U.S. dollar.

That said, there is an easier way to do this without having to track another indicator. It would also keep the currency performance impacts separate.

My Dual Momentum Process

In my process, I test the relative momentum component first.

I begin by identifying which broad stock market class is performing better: U.S. stocks or International stocks. Once we've identified the stronger of the two major equity markets, we ensure we are investing in a rising asset by checking the absolute momentum of that market.

In this slight variation of the process, we can eliminate the risk of holding bonds while foreign stocks and currencies are doing well.

Relative Momentum First or Absolute Momentum First: U.S.A.

Sources: TheRichMoose.com, MSCI Inc., FRED

When comparing the two methods of Dual Momentum using U.S. stocks as the base, there is a slight historical performance advantage for testing absolute momentum first.

In this backtest, both methods are very comparable over the test period with the only substantial deviation occurring in the early-1970s. Even in this period, my suggested method quickly caught up to Gary's method by the end of the decade.

In the end, an investor testing for absolute momentum on U.S. stocks first (Gary's method) would have realized a +16.14 percent compound annual return during the test period.

The same investor testing for relative momentum of equities first (my method) would have realized a +15.93 percent compound annual return. This is effectively an indiscernible difference.

We can also look at a rolling period return to examine the differences in returns between the two methods more closely.

Sources: TheRichMoose.com, MSCI Inc., FRED

Testing absolute momentum first with U.S. stocks does show a general advantage earlier in the test period. The noticeably better performance at the start of the testing period largely stems from a single month in 1973 where the relative momentum first model had the investor in International stocks while the absolute momentum first model had the investor in bonds.

While one month does matter, we can't ignore the snap back in the following years where the relative momentum first model quickly caught back up.

The performance advantage of Gary's model has shrunk to nothing in the past two decades. I suspect this may be due to the corresponding rise of China and an expanding European Union during this period.

Relative Momentum First or Absolute Momentum First: Japan

Sources: TheRichMoose.com, MSCI Inc., FRED

Japan provides us with a stress test example of a highly diversified, high impact market going through a period where local stocks performed poorly while International stocks did extremely well.

To perform this test, I used the MSCI Japan Index, MSCI Kokusai Index, the MSCI ACWI ex-Japan Index, and Japanese CD data from the Federal Reserve Bank of St. Louis. All momentum evaluations used a 12-month lookback period and all data was priced in Japanese yen.

In this simple backtest, we can clearly see the many periods where Japanese stocks were underperforming CDs. This would put the investor into local bonds when absolute momentum was evaluated first (Gary's method). The investor missed years of International stock market exposure.

However, when doing a relative momentum evaluation first (my method), the investor was able to participate in International stock growth while the local market was underperforming.

In the end, an investor testing the absolute momentum of local stocks first would have realized a reasonable +8.03 percent compound annual return. The same investor testing relative momentum first would have realized a +10.46 percent compound annual return.

As seen by the chart below, the performance advantage for testing relative momentum first was noticeable across most time periods.

Sources: TheRichMoose.com, MSCI Inc., FRED

I acknowledge Japan might be a bit of an anomaly as an enormously inflated stock market going into the late-1980s. However, it does show us a recent example using a very diversified market, one that has a meaningful impact on the global economy, and a country with reserve status currency.

Conclusion

As long as the U.S. economy is the world's leading economy and the U.S. dollar is the base currency for global currency valuations and global economic activity, the method of testing absolute momentum first in the Dual Momentum model should work.

While U.S. stocks and the U.S. economy have performed well this past century and have been a leading indicator of the global economy, this phenomenon is likely to subside as the U.S. declines in relative impact. Just as the U.S. rose to prominence in the early 20th century, China and India are rising today.

Gary's method of evaluating Dual Momentum relies on the performance of U.S. stocks to get exposure to any equities. This limitation in the process needlessly exposes investors to single market risk.

Single market risk is very real. We can see the negative effects of a single market on Dual Momentum when we apply Gary Antonacci's process to Japanese stocks. Although Japan is not the U.S., it is also not a fringe economy with a non-influential currency or small global impact.

Given the shifts we are seeing today, it is not out of the realm of possibility that the U.S. experiences a similar decline in market influence, becoming a market laggard instead of a market leader.

We can significantly reduce our single market risk by slightly changing the Dual Momentum process. Instead of testing absolute momentum on U.S. stocks first, we should start with a relative momentum evaluation on our equity assets. We will still always test for absolute momentum on the better performing equity asset to ensure we are not investing into a declining market.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.