Dual Momentum: A Look at Market Cycles

Dual Momentum is one of my favorite investment strategies for do-it-yourself investors. The historical performance of Dual Momentum—even in the now effete twelve month lookback form—has been fantastic going back nearly seven decades.

There is no other strategy I can think of where investors can experience double digit annualized gains over full market cycles with 25 percent drawdowns (in the worst case) and just a couple trades per year.

Although the long backtests are beautiful and the results are solid, Dual Momentum has come under a lot of fire lately. Investors who employed the strategy are losing faith after several shakeouts in the past couple years, the quants are poking holes in the mechanics of the strategy, and the buy-and-holders are flaunting massive gains as the market keeps jumping up on every dip.

An argument that's been made before, and I've been on that side as well, is that we can expect equity trend strategies to underperform the index in the upside portion of market cycles. This is often observed in single market backtests. As a trend strategy, Dual Momentum would fit this argument.

However, Dual Momentum doesn't just beat the benchmark by a few points annualized as we see with single market trend models by avoiding long downtrends. Dual Momentum has crushed the market by also picking the strongest equity class—U.S. or International—in the broader market upwards half-cycle.

I want to focus on the "bull market" or upside half-cycles in U.S. equity markets because this is where trend investing can tend to underperform equity portfolios. To help put this relative performance into a visual format, I decided to look at all the "bull market" phases since 1970. We'll see how a Dual Momentum investor would have felt standing beside the S&P 500 and a balanced portfolio (33.3 percent U.S. stocks, 33.3 percent International stocks, and 33.3 percent bonds).

We know Dual Momentum has avoided the deep drawdowns of extended market downwards half-cycles. In other words, I believe it is unlikely to see a Dual Momentum investor complaining about their recent performance at a time like the summer of 1974, summer 2002, or fall 2008.

July 1970 to December 1972

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

In this short bull market Dual Momentum underperformed the benchmark portfolios for more than a year into the cycle. Dual Momentum quickly caught up in the latter half of this half-cycle, essentially meeting U.S. stock performance at the cycle peak.

October 1974 to November 1980

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

The dynamics of the late-70s upwards cycle was very similar to the brief earlier cycle. Stocks ran hard at first with Dual Momentum lagging behind for the first half of the cycle. However, later in the cycle Dual Momentum caught up again, barely edging out stocks over the entire half-cycle period.

August 1982 to August 1987

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

While the mid-1980s market half-cycle started off similar to the previous bull markets in the 1970s, it certainly finished different. Dual Momentum lagged at first, for approximately a year and a half, but the signal moved the Dual Momentum investor into International stocks. For the next few years International stocks wildly outperformed U.S. stocks and a Dual Momentum investor finished the half-cycle much wealthier than an American focused investor.

Even the normally lagging Balanced Portfolio performed neck-and-neck with U.S. stocks. While the bond component may have held returns back, the International stock allocation gave the Balanced Portfolio a lot of strength into the latter half of the upwards portion of the cycle.

We all know what happened to U.S. stocks in October 1987. What many people don't know is that International stocks did much better in that crash comparatively. By holding International stocks, Dual Momentum did better in that sudden crash, even with a full equity allocation.

November 1987 to August 2000

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

As the chart shows, this long market upwards cycle was almost all U.S. stocks driving the performance. Dual Momentum got a bit of an edge on U.S. stocks when the market shifted to bonds in 1990 and to International stocks in 1994.

Overall both Dual Momentum and U.S. stocks gave a 9x return in little more than a decade. The momentum was so strong that the Dual Momentum signal held in U.S. stocks for the 1998 Bond and Currency Crisis, riding to the peak of the U.S. telecom and tech bubble.

October 2002 to October 2007

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

This half-cycle we're back to the familiar performance of Dual Momentum lagging the market for the first half of the upwards cycle. Again, Dual Momentum finishes strong as International stocks took off in the mid-2000s. In fact, Dual Momentum had investors in International stocks for the vast majority of this half-cycle.

March 2009 to April 2019

Credit: TheRichMoose.com, MSCI Inc., FRED-Federal Reserve St. Louis.
Right-click to enlarge image.

This market half-cycle has been a significant deviation from the past cycles we've looked at. Normally, a couple years into the cycle, Dual Momentum would surpass the returns of the Balanced Portfolio and U.S. stocks. and pull away from there.

Although I don't have data going as far back as Dual Momentum's publisher, we have never seen Dual Momentum perform this poorly in a market half-cycle. Dual Momentum has never lagged the S&P 500 or a Balanced Portfolio by so much for so long.

For some perspective, U.S. stocks would have to fall 60 percent to match Dual Momentum's returns over this market half-cycle. It would take a 25 percent decline for the Balanced Portfolio. This number isn't impossible. In fact, very prominent market researchers have been suggesting a 60 percent decline in U.S. stocks would be necessary just to get us back to a baseline historical valuation.

For myself, I am not sure where markets are going to go. One thing I do know is that zooming into shorter period performance can help us get a picture of how a strategy performs.

If there are clues that something may be shifting in the performance of a strategy, we need to keep a more careful eye open. In my research I've seen long-term shifts in other investment strategies; once winning strategies becoming laggards. Of course they are only seen in hindsight, but it is important to look for these shifts before they drag down your portfolio returns for decades.

While I'm not abandoning Dual Momentum, I am somewhat less confident in the strategy than I used to be. It would take a pretty solid relative performance in the next downwards half-cycle to renew full confidence in the strategy. Gary Antonacci has previously mentioned that he would look to full market cycle performance to determine the effectiveness of Dual Momentum. I would say that a potential challenge is in the works.

For now, I am still comfortable staying with Dual Momentum for a good portion of my portfolio. However, as I've advocated for many times before, don't put all your money in a single strategy. Mix it up. Spreading your bets across a few strategies can reduce a multitude of risks much better than small adjustments within the strategy that try to adapt to market conditions or reduce some of the risks present the strategy.

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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

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

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