Average yearly alpha around 8%
With default settings, since the early 1980es, this strategy has beaten the market
With the awfully boring 1990s behind us, it’s time to look at a much more interesting period: The 2000s. During these 10 years not only did we see a prolonged period of a downwards trend during the first few years, we also saw the market go off a cliff towards the end, later named the Great Recession.
Peeking at just above 1500 towards the end of August, 2000, the S&P 500 started falling and didn’t stop doing so until around February 2003. It was then at just above 800. You’d really need to have good nerves if you blindly believed in the market going up in the long run during a period like this. So how did the indicator capture and react to such a clear downwards trend?
Below is the first half of this decade, showing the indicator value and market:
Not only does the indicator capture this perfectly, giving a clear indication from the beginning of May 2000 when it drops to a value of 6, but it generally stays low till the end of the downwards trend picking up in value again around February/March 2003.
Within that period there are two attempts at moving to a higher indicator value. The first, during the middle of 2001 is short lived and doesn’t bring much. The second is stronger, reaching a value of 91 in November 2001, starting the month before and did managed to capture some of a small upswing within this overall downwards trend.
What then happens early in 2003 is a gradually stronger indicator. This actually starts happening mid-2002, but is too low to act upon. Generally staying strong from then on we’re able to perfectly capture the trend reversal and enjoy the market upswing all the way till the beginning of 2004. Here we now see the indicator beginning to fall again, in reaction to the now changing market conditions. Even if the market is going slightly down in this period, mid 2004, you might want to call it a sideways market. We end this first half well, again enjoying an upwards moving market.
Before moving on the the next half, let’s look at parameters. During the 1980s the most optimal indicator cut-point was 40, producing an alpha of 7.80% pa. During the 1990s, the most optimal indicator cut-point was 30, producing only the slightest advantage. For this first half of the 2000s, the optimal point was 30, but 40 wouldn’t have done bad either. Again we see persistence in the parameters, crucial if we are to apply the indicator, with 30 showing the overall best results. If you need a recap on how these parameters are applied, have a look at this post, in addition to the “learn more” page.
Below is the second half of the 2000s, again sticking to a cut-point of 30:
Besides the first stretch, it’s pretty nasty. Sadly, being honest, the indicator didn’t manage to react early enough to get out at the peak. But it did manage to give a clear indication at the very bottom. In fact, it might have reacted slightly early, which is not necessarily a bad thing, but does give a rather nasty drop in our actively managed portfolio when we choose to re-enter the market at the beginning of 2009. In reality you could argue that given a more advanced trading strategy we could enter the market in a more risk averse manner than simply going long as is done in the web app. But we’re keeping things simple for now. And we still managed to produce an alpha of over 10% pa during this last half, so things are not bad.
This post has been slightly delayed, for two reasons:
- The FIFA World Cup is on, so plenty of reasons not to bother writing blog posts
- The 1990s was pretty boring, with regards to our benchmark index
So what are we left with then?
Let’s assume you had access to the AgoraOpus indicator at 1st of January 1990. And you did some back-testing and landed on the most optimal indicator cut-point, according to your preference. Looking back at the 1980s, this is what’s you’d pick for that period:
Applying the same parameters blindly to the next 10 years during the 1990s would have given you this:
Although not as fantastic as the 1980s, it’s nothing to cry about. What can you expect with no big shorting opportunities? And finally, if we optimize on alpha, the optimal point was just 10 off the selected. That’s an important point: We’re starting to see persistence in parameters. This is something you want with any type of trading system.
I’ll leave it at that for now, and promise you a lot more excitement in the next decade. Till then, enjoy the world cup!
If it wasn’t for one particular event, the 1980s didn’t bring much excitement. That is of course if you exclude the birth of personal computers, amazing fashion sense, hair and fantastic TV entertainment.
But we’ll stick to focusing on US financial markets here. As we can see below, things are nice and calm for about 3/4 of the first part of the period. But then, if you didn’t know any better, you might think that the massive drop is some kind of data issue. It certainly looks like a big outlier, that’s for sure.
That outlier, or black swan as it’s also called, was not some kind of data measurement issue, but instead the Black Monday event. This event came out of the blue for most people, both those who should have known better, and certainly the rest. But we can also notice that the blue line above, indicating here how the indicator is applied, doesn’t seem to be much affected by this event. How can this be? Let’s start by zooming in around that massive drop, happening on Monday, October 19, 1987.
This first thing to note is the gradual decline in indicator value (blue line in top graph) from close to 100 (which is maximum value) down to 57 before it falls off a cliff, all the way down to around 10. With zero being its minimum value, this is as close to bottom as you’d typically get. This indicates bad news!
The second thing to note is that this happened way in advance of the drop in the stock market (green line in bottom graph). The final big drop in our indicator value, from 57 to 12, occurred on 25th of September 1987, almost a month in advance.
I’m sure you can find some other gems in there, but nothing dominated the market like that one event in the 1980s. I’m pleased the indicator gave such a clear indication, with so much lead, so I’ll leave it at that for now. Till next time!
First a little recap: The AgoraOpus Market Opportunity Index is a fully algorithmic indicator value, calculated and published after market close every Friday. As of now only the index tied to the S&P 500 is publicly available, and it can be accessed either through the web app or via the github repository.
As of writing this, the range of data available is between 1981-10-30 and 2014-06-06 (your browser might need a few seconds to render all of it) and it has given a positive yearly average alpha above 8% within that range. So here’s an attempt at giving you an initial view of the whole picture.
Let’s first start by getting to know the indicator a little better by getting a feel for its distribution:
The indicator range is from zero to 100, both inclusive. Each bin/bucket in the above histogram spans 5 distinct indicator values, with the exception of the final, which spans 6 distinct values. Clearly we have a tendency for the indicator to prefer staying in the middle. Combine that with the fact that historically speaking the S&P 500 has gone up on average in this period and it is tempting to say that the indicator is slightly biased. This bias would lead us to prefer a cut off point somewhere to the left of the middle for when to go short/reduce exposure.
Next let’s look at what market returns we’ve seen for these various indicator values. The returns are here selected in the future as described in how we apply the indicator article, and represent the passive S&P 500 log-returns.
Both average and median returns tell a similar story: If you want to maximise your returns, increase your upside exposure with indicator values above 30. What this graph doesn’t show you is how it looks within subsections of the overall time range. The below graph attempts to show you this. Instead of average/median returns, the log-returns are here summed up and grouped by decade:
Each of these decades deserve more analysis individually in later posts, but this will do for now. As always, your feedback is welcome. Anything you’d want me to look into specifically, let me know!