Last week marked the four-year anniversary of the start of the current bull market. Today, review how momentum and tactical allocation can succeed in all environments, not just the positive ones.
Last week marked the four-year anniversary of the start of the current bull market, and stocks have been extremely productive during this period. Since the S&P 500 bottomed in October of 2022, the index has risen 114%, moving from 3,577 to our current levels around 7,660. Other areas of the market, namely technology, have been able to surpass that by a wide margin, with the Technology Select Sector SPDR ETF (XLK) gaining 215%. On the other hand, there will always be areas of the market that lag behind, with five of the eleven major sectors rising less than 50% during this bull market (real estate, staples, utilities, healthcare, and basic materials). While most strategies will be positive in a bull market, momentum typically has the advantage of being able to overweight areas of strength like tech to outperform the broader market as sustained leadership trends emerge.
However, not all periods are as kind to markets. For every bull market, there’s always a corresponding bear market before and after. Most notably, the lost decade from 2000 to 2009 saw the S&P 500 decline 9% over a ten-year span, while other periods, highlighted below, experienced similarly sharp declines. While the bull market is intact for now, markets can pivot on a moment’s notice. Thankfully, tactical allocation allows investors to adapt to those environments as they shift, even when stocks decline. As a result, we wanted to review how momentum and tactical allocation can succeed in all environments, not just the positive ones.
How Does Momentum Adapt to Bull and Bear Markets?
One of the most popular models on the site is the FSM T. Rowe Price 5S PR4050 model, which uses the fund score methodology to select the strongest mutual funds in T. Rowe Price’s lineup, while also employing a cash trigger during periods of extreme weakness. One way to view how momentum adapts is by comparing the exposure of the model in bull and bear markets. Given the shifting nature of holdings in a model, especially with funds, it’s hard to pinpoint exact allocation to different groups over time. Rather than focusing on holdings, we can look at the correlation (or similarity) of the model to different groups.
In terms of broader asset classes, the model has been 83% correlated with domestic equities (SPX) during bull markets, but that falls to 69% during bear markets, highlighting reduced exposure when markets are falling. That change has been even more pronounced for international equities (ACWX), with the correlation falling from 81% in bull markets to 53% in bear markets. Conversely, the model has been more correlated with fixed income during bearish periods as it potentially diversifies to other areas.
In addition to asset classes, momentum will pivot towards different factors, such as growth and low volatility, depending on the state of the market. Over time, the T. Rowe Price model has been more correlated with more aggressive factors like growth during bull markets. Meanwhile, more defensive factors like yield and low volatility tend to see a smaller increase (or even a decrease) in correlation during bull markets. Said differently, momentum tends to rotate between risk-on and risk-off factors depending on how strong the market is.
Lastly, sector rotation plays a large role in the success of most momentum strategies. Higher beta sectors like tech, communications, and discretionary typically perform better during bull markets, while the opposite is true of lower beta sectors. As investors would expect, momentum tends to be more correlated with these aggressive sectors when markets are rising. Conversely, the most defensive sectors (staples, healthcare, utilities) tend to see higher correlation during bear markets. Over time, the adaptive nature of momentum has allowed the model to navigate to bull and bear markets alike.
Momentum Performance in Bull vs. Bear Markets
Since the model’s inception in 1997, there have been five separate bull markets. The average return of the S&P 500 during those bull markets has been 201% when including dividends and dividend reinvestment. Meanwhile, the T Rowe Price model has averaged a return of 227%, highlighting the benefit of overweighting areas of relative strength.That said, investing is far easier when everything is moving higher. The negative reaction from a 30% decline is typically far greater than the positive reaction from a 30% gain.
Bear markets are where advisors and clients are tested the most but can also be an opportunity to add the most value. Looking at the four bear markets over the last thirty years, the S&P 500 has averaged a decline of nearly 40% during the average bear market. However, moving to cash and relatively stronger areas has allowed the T Rowe Price model to average a decline of only 21.5% during those same bear markets, outperforming SPX during each of those four periods. While no investment strategy or approach is immune to periods of underperformance, momentum has shown long-term resilience regardless of the market environment it faces.
