I’ve included the word “revisited” in the title of this week’s article because the topic is definitely something that I have written about in the past.  In fact, the system that I will revisit today is one that I first wrote of in “Technical Analysis of Stocks and Commodities” magazine over a decade ago. 

While the system has had its ups and downs over the years it remains a very good example of a “bread and butter” strategy, i.e., the type of method that an investor might consider as a “core” strategy (boy I sure do like to put things in quotation marks, don’t I?).

The implication of the phrase “There’s Always a Bull Market Somewhere” is that, well, there is always a bull market somewhere (caveat: with the exception of October 2008, during which time there was only pain and misery, but I digress).  In other words, there are always opportunities out there to make money.  

The trick of course is figure out where those opportunities lie.  There are a heck of a lot of pretty “sophisticated” strategies out there today, still no one should be surprised that a very "simple" approach can often work just as well or better than a more complex approach.  To wit…..

Jay’s “Pure Momentum” Method

Pure Momentum (or PM for short) is the name I gave this strategy when I first wrote about and started using it back in the late 1990’s.  A lot has changed since then (OK, I guess I should have prefaced that statement with a “Massive Understatement” warning).  “Back in the day” (and should I be troubled that I find myself using that phrase more and more these days?  On second thought, don’t answer that) the only way to play stock market sectors was either to buy a group of individual stocks as a proxy or to trade Fidelity Select Sector funds.  I chose the latter course. 

With the advent of ETFs and via mutual fund offerings from ProFunds and Rydex fund families, Fidelity is obviously no longer the only game in town.  Still, as the market for sector funds evolved I was haunted by one recurring thought - I was an “old dog” and these were “new tricks.”  So while I have in fact found many uses for sector ETFs, I still follow this particular method via Fidelity sector funds.

Now to understand the concept underlying the Pure Momentum method and its genesis, let’s consider some “complex” ideas:

Complex Idea #1) A bull market is unofficially defined as “something that is rising in price”.

Complex Idea #2) to find something experiencing a bull market look for “something that is rising in price.”

OK, perhaps that wasn’t so complex after all.  But like I said, sometimes simple ideas are the best.  Anyway, getting back to Fidelity, while I have developed a personal affinity for the family and the funds over the years, the fact remains that they are somewhat militant about frequent switching in and out of their sector funds.  The bottom line is essentially that if you trade the same sector fund more than once a month you can expect to pay extra fees that can eventually take a meaningful bite out of your returns. 

So at this point in the strategy development stage the choices are:

Door #1) Whine and complain (certainly a popular choice these days)

Door #2) Find another trading vehicle

Door #3) Trade Fidelity sector funds using a method that doesn’t trade more than once a month

For our purposes I am going with Door #3. 

The Underlying Concept of Relative Strength

The concept underlying this method is basically that something “in motion” is more likely to continue in that motion than it is to immediately reverse course.  As it turns out fundamental changes in a stock market sector or industry group can take a long time to play out.  When the fundamentals improve for a given sector – such as financial, technology or energy stocks, for example – it’s not like all the stocks in that sector double or triple overnight.  First they bounce off their lows, then they start to advance, then people start to recognize that they are advancing, then several months down the road you start getting positive “earnings surprises” and a whole new slew of buyers pile in and so on and so forth.

This process can go on for many months or even several years at a time.  So the way to find the winners is to look for, well, the winners, i.e., the sectors that have already been performing relatively better than the others.

The Pure Momentum “Trading Rules”

I put the phrase “trading rules” in quotations because (well, for one thing, I just do that “a lot”) it sort of seems like a stretch to use that phrase, as you will see in a moment.  So here goes:

Rule #1) After the close of trading on the last day each month, identify the five Fidelity Select Sector funds that have advanced the most during the past 12 months (for the record I use 240 trading days but month-end numbers result in the same positions about 99% of the time).

Rule #2) Buy and hold those five funds for the next month.

Rule #3) Repeat.

So basically, any switches that occur will take place on the first trading day of the month.  OK, now when I said earlier that I like to keep things simple, chances are you thought I was understating things a bit.  And chances are that at this point you are saying to yourself, “Wait, what, that’s it?”  In a word, “yes”. 

First the Caveats

Before highlighting the results from using the rules above, a couple of quick caveats.

-I started tracking this method in real-time in 1999, after back testing it from the end of 1989.

-This is far from the long sought after “you can’t lose trading [your favorite trading vehicle here]” strategy.  Significant pullbacks in equity will occur.

-I am not suggesting that everyone rush out and start using this method.

-There are many ways to “tweak” the basic concept of this method and lots of alternative trading vehicles available.

All right then, backside sufficiently covered, let’s take a look at the results.

Pure Momentum - The Results

Figure 1 displays the hypothetical year-by-year results and Figure 2 displays the yearly cumulative results. 

Figure 1 – Year by Year; Pure Momentum versus S&P 500

Figure 2 – Annual Cumulative Growth of $10,000 invested in Pure Momentum (blue line) versus S&P 500 buy-and-hold (red line)

There are clearly some key things to note during the 23 full years of results through the end of 2012:

-2011 was a dismal year for this system.  It lost over 17% while the S&P 500 eked out a fraction of a percent gain (Did I mention this was not “the perfect system?”).  Other relative figures appear in Figure 3.

Figure 3 – Summary of Results

The Pure Momentum portfolio at the end of February 2012 appears in Figure 4.

Figure 4 – Pure Momentum Portfolio for March 2013

Summary

The purpose of this article is not to convince you to trade Fidelity Select sector funds - nor anybody else’s sector funds for that matter – nor even to use the Pure Momentum method at all.  The overarching purpose is this article is twofold:

1) To illustrate that relatively simple concepts can work well over the long-term so long as they have a solid foundation (in this case, the foundation is the concept of “relative strength”, i.e., that a sector that is currently acting well may to continue to act well for a period of time).

2) To highlight the fact that stock market sectors are in fact a good place for people to look if they wish to attempt to outperform the market averages.

OK, that and it also gives me the opportunity to put more things in quotation marks, which seems to be a “thing” for me.

So hey, “Mission Accomplished.”

Jay Kaeppel

Staff Writer and Trading Strategist

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