As an trader who has strong believe in momentum and market timing. The "target date funds" and "lazy portfolios" are not for me in terms of 401K investing. I have total 31 funds in my fidelity account, 14 out of 31 are stock funds (taking out target date funds and monetary/bond funds) with minimum holding period of 1 month. How to best use those funds to max return is one of my focus in past a few months. After study, there are 2 strategies that makes sense to me:
1. Stockbee Lemonade for 401K
2. Pure momentum strategy
Stockbee has most credit for me to come up the 401K. Basically the Lemonade Strategy is: market timing + rank funds with momentum. The
enter signal is: market turn bullish after reach extreme bearish; the
exist signal is: market reach extreme bullish. It only invest in certain period of market, basically it is fat-pitch method trying to catch only the major moves of bull trend. During the holding period, hold concentrate positions on top 1 or 2 stock funds ranked by 2 months momentum (TI42), adjust and rotate positions if funds rank drop out of top3 (or 20% if you have more selections than me in 401K funds).
For pure momentum strategy, it does not use external marketing timing tool. The funds selection (here include both stocks funds and momentary/bond founds) is only based on momentum (e.g. TI42). In the bull market, stock funds will have highest momentum; while in bear market, stock funds will have worst momentum and thus will force you to rotate portfolio to monetary/bond funds. In other words, the market timing is built in the funds selection method. To further improve this method, a momentum threshold can be applied to stock funds. We can use TI42=1.01 as threshold. When any of the stock funds get 2 months momentum above this level, we move position to stock funds. If all stock funds momentum drop below this level, we then rotate to monetary/bound funds.
What is the performance for these 2 strategies? In past 10+ years, the Lemonade has an average of 34-35% yearly return with no negative years; the pure momentum strategy has an average yearly return slightly above 20% with maximum draw-down of around 15%.
Let us look at more details regarding the yearly numbers. For both strategies, most profit comes from the earliest and strongest rally at the beginning of the economic cycle. During 2003-2004, 2009, both strategies had triple digital annualized return which is significant above the average. In the other years, the yearly return will be from somewhat to well below average. Both strategies will avoid big bear phase of economic cycle, which is the key compounding works and the reason that return beat index, beat target date fund or lazy portfolios.
So why pure momentum strategy under-perform the lemonade strategy? First and main reason is the built-in market timing signal is lagging signal. It will miss the early move of major rally. While market bottom in March of 2009, index rise 25% in just one month. This one month profit may be more than entire year return of other time. For same reason, pure momentum strategy may get out too late when market move to bear phase, cause some damage to portfolios.
Second reason, after a major rally, market tend to form complex top (whipsaw territory), generate frequent buy and sell signals for pure momentum strategy while lemonade get out early at signal of primary reach extreme (it will miss some profit here). During this topping period, when you get in stock funds, rally end; when you get out stock funds, market bounce back. One exception will be Middle 2013 to early 2014, after market reach primary extreme, with shadow correction, it keep moving higher and higher. During this period, I would expect pure momentum strategy out-perform lemonade. But over long time, exit early is not bad.
So far as I know, Stockbee Lemonade is the best 401K investment strategy. The most difficult part and also the reason its return is outstanding is the market timing. Previously, I have written
an analyst of Stockbee primary indicator. Stockbee really did excellent work on market timing using market breath, there is no need for me to re-invent the wheel.
To better understanding how the market monitor works. We need to understand the time frame of the trend. There is very long term trend in line with economic cycle, Fed funds rate and Fed's balance sheet are the key role in this time frame. There is major trend (long term), determined by primary market breath and finally short term trend determined by secondary market breath. The explain is as below:
a. Monetary Conditions ---- Very Long term ---- one business cycles (4-10 years)
b. Primary Market Breath ---- Long term ---- 6 months ~ 1 year
c. Secondary Market Breath ---- Short term ---- 1 week ~ 1 month
For Lemonade 401K strategy, it is a fat-pitch method trying to catch the major trend of the market. The time frame is in line with Primary Market Breath which is the one we should focus on. The major move tend to start with extreme bearish of primary indicator and end when primary indicator reach extreme bullish level. That is how the buy and sell signal generated.
Shorter move is out of focus as the limitation of holding period in most 401K account, which can start from medium bearish level instead of extreme level. Very long term monetary condition is important though, which provide the context of the primary market breath. When trying to catch the major breath trend, we also want to know where we are in the economic cycle.
- When monetary condition is in favor (bull phase of business cycle), market tend to correct only 10-15%, that's where you need to start to be bullish and stay focus.
- 20% plus correction is accompanied by some trouble in macro-economy, and will reflex in interest rate jump and/or Fed monetary policy change. Which tend to be bearish phase of business cycle.
- After a 20% + correction, we are at the start of new bull phase of business cycles (normally with aggressive interest rate cut and monetary policy change to favor). Market tend to strong rally for next 12-18 months (2003-2004, 2009). It is better to stay full invest during this phase, and big fortune is generated here. Do not worry about 5% kind of pull back. Also, extreme bullish reading can happen at the beginning of 6 or 9 months, this is not sell signal but actually tell you how strong the rally it is in a fresh bull cycle.
At last, devils are in details. Let us look at the other tactics for lemonade strategy. I am not ready to execute this strategy unless I fully understand every aspect and tactics of it:
- What happens at the bottom: sequential big selling, primary reach extreme bearish (early/leading signal), 10 day breath ratio < 0.5. Suddenly selling exhausted and buying step in generate a breath flip (bottom happens right now). Within a few days, 10 day breath ration > 2 and finally primary indicator turn green (lagging or confirm signal). Bottom tend to happen in very short time, the opportunity window is only 3-5 days. In order to catch it, we must be stay focus and full prepared.
- Funds selection is different right at the bottom. None of the stock funds get momentum here. So we should choose the worst performance fund (lowest TI42 reading) or funds with largest beta in history as they tend to rally fastest after market turn. After one month period, if bottom confirmed, then apply regular ranking and rotate position based on momentum high to low.
- Usually, breath indicator gives very accurate bottom signal. But it is not 100% guarantee, still small chance that we get in early and market has further room going down. After entry, the position has been lock for one month, if we are correct, primary should expanding with market move higher fast; if not the case, it like to be wrong, be prepare to get out and wait for next signal. Breath flip in extreme condition is strong signal, even it is wrong like Nov 2008, it only generate a short term rally instead of start of bull phase. Still rally is longer than one month. So 100% in at bottom signal is justified, the chance of losing money is small, the change of catch a major bull rally is high.
- When market rally for several months and reach extreme bullish level. This is the exit signal. But it does not mean that we need to close stock funds positions immediately. We should stop rotate the position even it drop below top3, otherwise it will be lock for another one month. And partly move some position to monetary/bound, once market show weakness (big selling days), then close all the stock funds position.
- Regarding the extreme level in primary indicator reading. Stockbee said when Quarterly 25% move issues goes below 200, it is indicate the extreme condition. This number can be inter-day instead of end of day. Also at March 2009, number goes to 480/2600 right before the turn. Although 480 is more than 200, but 2600 on the down side is really big number. Consider this number as an art instead of science.
