Momentum trading is the opposite of buying low and selling high: momentum is about buying strength. Can we make a successful momentum strategy for S&P 500?
Yes, a momentum strategy for the S&P 500 works. We use monthly bars and a simple moving average strategy crossover system.
Let’s show you why a momentum strategy works:
What is momentum?
First, if you are unsure what a momentum strategy is, we recommend an older blog post we made:
Does momentum work?
Momentum investing is an approach that seeks to buy stocks with the best historical performance over a given period and then periodically rebalance the portfolio such that at any given time, it’s invested in the stocks with the highest momentum.
This approach is based on the momentum hypothesis, which believes a strong correlation exists between 3-12 months ‘historical return and 3-12 months’ future return.
That is, stocks that performed the best over the medium term (3-12 months) are likely to continue performing well in the near future, say the next 3-12 months.
How momentum investing works
Here’s how it works:
- A momentum investor buys stocks that have performed best over the last 6 months (can be 3, 9, or 12 months)
- The investor rebalances his portfolio every month or 3 months by selling the least performing ones and buying new stocks currently performing better.
Why does momentum work?
We need to look at some facts to understand why momentum investing works:
Eric Crittenden of Long Board Funds published a fascinating blog post in 2016 called 80 Percent Of Stocks Have A Lifetime Return Of Zero.
Crittenden looked at the distribution of returns for all stocks listed between 1989 and 2015. Put short, over the long term, a small minority of stocks drive all the returns for the overall market!
Approximately 20% of all stocks accounted for all the gains during the period, meaning that the remaining 80% accounted for zero returns. During the same period, S&P was up 12-fold! The majority of the stocks ended up worthless.
It’s like the Pareto principle:
Roughly 80% of consequences come from 20% of causes – the 80/20 rule
This is what the distribution looked like:
We quote from the blog post:
7.7% of all active stocks outperformed the S&P 500 Index by at least 500% during their lifetimes. Likewise, 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%. The remaining 12,404 stocks performed above, at or below the same level as the S&P 500.
What are the implications of the research?
Navigating the market may be more efficient by playing defensively and avoiding underperforming investments.
Can this be done?
The fact is that picking winners is very difficult, but this is where momentum investing might come to the rescue: you are buying strong stocks and avoiding weak stocks.
(Eric Crittenden’s blog post was written before Hendrik Bessembinder published his famous paper Do Stocks Outperform Treasury Bills?)
Let’s backtest a simple monthly momentum strategy for S&P 500:
S&P 500 momentum strategy – trading rules
The trading rules can’t get any simpler:
- When the close of the current month crosses above the 12-month simple moving average, we go long.
- When the close of the current month crosses below the 12-month simple moving average, we sell (and stay in cash until we get a buy signal).
This is it – two simple rules. You can also enter at the open of the following month after a signal.
S&P 500 momentum strategy – backtest
Let’s backtest the strategy and evaluate the trading statistics and results. We used the cash index since 1960 for the backtest, and thus dividends are not considered, meaning the returns are understated, but that doesn’t alter the findings. We are interested in the relative performance between the strategy and the index; therefore, it should not matter.
Let’s look at the equity curve:
We started with 100 000 in 1960 and ended with 5.575 million in February 2023. This equals an annual return of 6.6% vs. buy and hold’s 7%.
The trading results and statistics are slightly worse than buy and hold, but we must consider that the strategy is only invested 69% of the time and has substantially smaller drawdowns (26% vs. 55%).
If we factor in the less time spent in the market, we argue the risk-adjusted return is 9.5% – substantially higher than buy and hold:
One of the reasons for the small drawdowns is the return distributions:
As you can see, there are a few losing trades, but that is more than offset by more big winners than losers. The average loss is less than 5%, while the average winner is almost 25%!
This is the complete trade list since 1960 (36 trades):
Does it matter what kind of moving average you are using? We tried two different ones (simple and exponential), and the former performed the best.
S&P Momentum Index
S&P has made a momentum index:
The S&P 500 Momentum Index measures the performance of stocks that show relative strength in the market (ticker code is SP500MUP). It’s an international index that covers all markets.
Since inception, the performance has been like this:
List of trading strategies
We have written over 1200 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies are taken from our landing page of profitable trading systems.
The strategies also come with logic in plain English (plain English is for Python trading and backtesting).
For a list of the strategies we have made, please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for: