Taming the Japanese Bear: Nikkei Case Study

In Institutional, Retail, Systematic Investing, Tactical Alpha on

The last post explored the efficacy of two simple strategies — a moving average approach, and a momentum strategy — in timing the S&P500, and compared these systems to a buy and hold strategy over the period 1971 – 2010. This period included an 11 year secular sideways market from 1971 until the Volker bottom in 1982, followed by one of the biggest and longest bull markets in history, from 1982 through the peak of the technology bubble in 2000. Post 2000, US stocks languished for three years before embarking on another 4-year rally to new all-time highs, and then they crashed again, by more that 50% in 2008-9. Of course, since then we have rebounded 100% from the lows in the sharpest rally nice 1937. What a wild ride!

We saw that two simple timing strategies would have beat the markets in terms of absolute returns, but more importantly, the strategies would have achieved these returns with a fraction of the risk experienced from buy and hold.

This post will examine how the same timing systems would have performed if applied against Japanese stocks since 1984. What makes this study especially interesting is that the price of the Nikkei has lost 22% of it’s value in absolute terms, which works out to annualized returns of -1% per year, over that 26 year period. At the same time US stocks are up 555%, or 7.75% per year.

The question is, can a timing system provide substantial positive returns even during a period where markets are substantially negative?

Chart 1. shows the price performance of the Nikkei from 1984 through the end of 2010. We can see that the market experienced a parabolic run to it’s peak in 1989 before beginning a 20 year bear market which took prices down 80% through the end of 2008. Note the annualized returns of -0.94%, and maximum total loss from peak value of 80% over this period (see “CAGR%” and “Max Total Equity DD” respectively in the table above Chart 1.)

Chart 1.

Source: Butler|Philbrick & Associates

Chart 2. shows the results of a test which applies a simple moving average to signal when to move to cash. As in the prior post, the system owns Japanese stocks when the index closes any month above the moving average, and holds cash otherwise. The results are substantially better than buy and hold, with positive returns of 4.7% per year, and a maximum loss of 43% from any peak, though the return series is a little choppy.

Chart 2.

Source: Butler|Philbrick & Associates

For Chart 3. we applied a relative strength rotation strategy to signal when to hold cash versus the index. Conceptually, this system makes use of a simple momentum system where we own the index when it has outperformed cash over the prior year or so, and we hold cash other wise. In this way, stocks earn their way into the portfolio by demonstrating positive returns over any prior 6 to 12 month period. If they haven’t earned their place in the portfolio by exhibiting strong prior returns, then it makes better sense to hold cash.

We can see that this technique delivered returns on the Nikkei of over 10% annually even while the index itself dropped 22% in value. Even better, this portfolio never dropped more than 19% from any peak value.

Chart 3.

Source: Butler|Philbrick & Associates

Lastly, and for giggles, we ran the same system as in Chart 3 above, but we also allowed the system to short the index in periods where the market exhibited negative returns over the prior 6 to 12 months. In this way we are able to earn returns while the market trends higher, and to also earn returns when the market trends lower.

Chart 4.

Source: Butler|Philbrick & Associates

By allowing the system to move into a short posture when markets are exhibiting negative price momentum, rather than just holding cash during these periods, we are able to extract over 16% annualized investment performance, while never dropping more than 23% from any peak portfolio value. And this during a period where the index dropped in value by 22%, from start to finish, and by 80% from peak to trough!

You may believe that markets only ever go up, despite having experienced no less than 2 major bear markets in the last 10 years, each of which erased half of total stock market value, and ignoring the evidence from Japan, which has experienced 20 years of declining prices. It is folly, however, to not at least acknowledge the possibility that market may not go up all the time. Accepting this possibility, doesn’t it make sense to explore other approaches to investing which may better position your portfolio for whatever the future might hold?