A Lower Risk Way to Play Defense

We've been cautious on the U.S. Equity Markets since publishing our April 24th Piece 'Tread Lightly'. Since then the S&P is virtually unchanged (-0.5%). Our rather defensive suggestion to go long Japan and short the Emerging Markets on May 9th has worked out well, with the exchange-traded fund EWJ outpacing ADRE by about 5%. See: Long Japan Short Emerging Markets.

For readers that are interested in another low-risk way to get defensive, we suggest looking at a 'Price Momentum with Reversal' Factor. We take the lead from Ford Equity Research and define this factor as being a stock's: 12 month return minus its 3 month return, minus 3 times its 1 month return. Thus, the factor scores high when a stock has been performing well over the last year, but has recently taken a breather.

To test the strategy, we form long and short portfolios by buying stocks that score in the top quintile based on the factor, and shorting the corresponding bottom quintile. We begin in March of 1999 (193 months), form equally weighted portfolios, and re-rank and rebalance on a monthly timetable. At first glance, there appears to be no relationship between the S&P 500 and the performance of this factor:

But if we look at this factor only during bearish periods, we see that the long-short portfolio performs well. We define the bearish periods as occurring during the following 51 months:

• The Tech Bubble Burst from 4/1/2000 - 9/30/2002 
• The Global Financial Crisis from 11/1/2007 - 2/27/2009
• The aftershock of the Global Financial Crisis from 5/1/2011 - 9/30/2011

Why not just short the market? Well, we could be wrong. This factor doesn't lose money during bullish periods (not shown), but it performs well during bearish periods. That sounds pretty close to a win-win!

In a subsequent post, we'll highlight individual names that look interesting on the long and short side of the factor. Stay tuned!