Greg Morris Core Rotation Strategy

I remember following Martin Zweig years (decades) ago and in fact used one of the
techniques he described in his book, “Winning on Wall Street,” in the mid-1980s'
(1984 to be exact). In it he described a really simple technique using his unweighted
index (ZUPI); trading it on a weekly basis whenever it moved four percent or more.
If it moved up four percent in a week, he bought, if it moved down four percent in one
week, he sold. Positions were held until the next opposing signal – just that simple.
The problem I had back then was not only in not following it as he described, but in
trying to tweak it into something better. Eventually experience told me that he had
already been down that road and I was the beneficiary of the results. Anyway, I took
this concept and used it on Index/ETF pairs, actually calculating the ratio of
Index/ETF pairs and using the weekly movement of four percent to swap between the
numerator and the denominator. It really works well with asset classes that are not
correlated, such as equity versus fixed income or equity versus gold, etc. Chart A
shows an example of this pair strategy using ETFs for the S&P 600 small cap index
(IJR) versus the BarCap 7-10 Year Treasury index (IEF). The ratio line is the typical
price line in the upper plot while the lower plot is the percent up and down moves for
each weekly data point. Remember, this is a weekly chart. Whenever the ratio line
moves up or down by 4% in a week as shown by the lower plot moving above or
below the horizontal lines shown as +4% and -4%. Repeated moves in the same
direction are ignored.

You can see that it appears to trade quite a bit; but remember it is weekly not daily.
And 10 round turn trades in almost 5 years really isn’t much. Think of the ratio line
like this: when it is moving upward it means the numerator (IJR) is outperforming the
denominator (IEF). So, here is how it works! I had to start that way because it is
confusing. When the Rate of Change (ROC) goes below the -4% line, it means the
numerator (IJR) is no longer outperforming the denominator (IEF). Hence, you want to
rotate into the denominator (IEF); or sell IJR and buy IEF. When the ROC goes above
the +4% line it means the numerator is now outperforming the denominator, so you
want to sell IEF and buy IJR. Also, the signals are at the crossing of the + and – 4%
lines, not at the peaks and troughs of the ROC. Confused? Try explaining it; I went
through 3-4 iterations. One last effort: Think of a buy signal (green arrows in Chart A)
as buying the denominator (IEF) and selling the numerator (IJR). This is completely
different than typical technical analysis indicators since you are trading a ratio instead
of individual security.

Red Arrows - buy IJR and sell IEF

Green Arrows - buy IEF and sell IJR

TEST QUESTION (rhetorical): Why wasn’t there a buy signal near the first of
October 2014?
 Ch
art A

An astute reader just pointed out a foolish mistake on my part. Here is the correct
Chart A below (Chart A-1) using ROC with parameter at 1 (not 4 like I had). I was so
focused on the explanation I wasn’t paying attention. Look at the above Chart A to
understand the process, then look at Chart A-1 to see the correct chart. Fewer signals.
The data in the tables was created using the correct process. Only Chart A was
incorrect. I figured this is better than just changing the original chart since so many
have already viewed it. I’m going to take a nap. Sorry!
 C
hart A-1

Using SharpCharts, you can do this ratio with a colon (:) between the symbols and the
indicator "Rate of Change" with parameter set at 1.

The ratio significantly outperformed each of the individual components (IJR and IEF)
and the S&P 500. Chart B shows the performance of the ratio with the numerator and
denominator swapped whenever there was a move of 4% or greater, the performance
of the individual components that make up the ratio, and the S&P 500.
 Cha
rt B

Table A shows the annualized performance statistics from 01/02/1998 until 12/28/2012
(weekly data). The Sharpe Ratio is slightly modified in that the return is used as the
numerator without a reduction for risk free return. The Ratio rotation strategy
outperformed in annualized return, and when compared to the equity component it
reduced the Drawdown (DD) considerably, improved the Sharpe Ratio, and lowered
the Ulcer Index.

Table A

I also found that smoothing the ratio with just a 2-period simple moving average
greatly enhanced the performance because it reduced the number of trades. Chart A at
the top of this article was without the 2-period smoothing; it might have reduced the
number of trades. Trying different percentages other than Zweig’s four percent
worked well occasionally, but overall, the four percent on weekly data yielded the
most robust results time and time again. The real advantage for a pair rotation strategy
is when it is used as a core holding situation. In other words, if a strategy required a
core holding percentage but that core could be actively managed, this would give an
actively managed core holding that would have much lower drawdowns that a buy and
hold core, and considerably better returns. I’ll expand on this concept with a Core
Rotation Strategy in the next article.
TEST QUESTION Answer: Repeat signals in the same direction are ignored.

My long-time friend and superb trader, Linda Bradford Raschke has finally written a
book about her life in trading. Folks, this is a great read that will offer so many tidbits
of knowledge on trading you won’t be able to put it down. I was honored to read the
draft and make comments. It won’t be on Amazon for a year, but you can order it
HERE.

Dance with the Trend,

Greg Morris

This article expands on the pair analysis discussed in the previous article. In that
article I showed a simple process of trading a ratio of non-correlated ETFs, in
particular the S&P 600 Small Cap (IJR) and the BarCap 7 to 10-year Treasury ETF
(IEF). Using a 4% trigger to switch from one to the other. Here I expand that concept
to build a strategy using 4 different ratios with each one representing 25% of the
portfolio. Table A shows the pairs used with an equal allocation of 25% each given to
the four pairs. This concept was originally designed to manage a core holding. Many
advisors want (need) a strategy that has a portion always invested in equities.

The fact is that these advisors are only following the guidelines their firm insists upon.
Most of the large brokerage firms insist on a maximum of 20% in cash or cash
equivalents. Hey, there are big commissions on cash. Of course it varies but most that
I dealt with would not let their money managers put their clients in cash, or at least not
much cash. Hence, here is a core strategy that is always invested and can be any
percentage of a portfolio.

T
able A

Chart A shows the results using the four different pairs in a core rotation strategy
compared to buy and hold of the S&P 500. The drawdown in 2008 was limited to only
14%, and other than that, it was a nice comfortable ride. The average drawdown (see
Table B) is only about 20% of the maximum drawdown. I was curious about the lack
of performance in 2012 and found it was the fact that in the Gold / 20 Year Treasury
pair gold was the holding the entire period.
Chart A

Table B shows the performance statistics for the Core Rotation Strategy (CRS)
compared to the S&P 500. In this rotation strategy example each of the pairs were
smoothed by their 2-period average prior to measuring the 4% rate of change. This
process removes many of the signals and while not affecting the results that much,
reduces the number of trades significantly.

Table B

Chart B is the drawdown of the core rotation strategy compared to the S&P 500. You
can see that the cumulative drawdown for the rotation strategy is considerably less
than the drawdown of the S&P 500 index. The average drawdown for the rotation
strategy was -3.39%, while the average drawdown for the S&P 500 was -15.88%. This
would make for a very comfortable core holding, considering the exceptional returns
and reduced risk statistics from just holding the index in a buy and hold situation. This
core rotation strategy still meets the requirement of an always invested core while
actively switching between four pairs of equity, gold, and fixed income ratios.

Chart B

An idea I’ve had but never followed up on is to build a series of 8-10 ratios and then
rotate into the 4 best performers on a relative performance-based measure. You could
model it after the hundreds of sector rotation strategies that are out there. I have never
cared for the rotation to be based upon a calendar time period; much prefer something
based upon relative performance among the choices.

Like all strategies or models, I write about, the one thing that will cause this to not
work, is the lack of discipline to follow it. Even when it appears that it is not working;
that is the time you must follow it. Discipline is the key to model success.

Dance with the Trend,

Greg Morris