When implementing the Dual Momentum strategy, one of the most critical decisions is how to allocate assets across different classes, such as U.S. stocks, international stocks, and bonds. The success of this strategy lies not only in selecting top-performing assets but also in managing risk by adjusting allocations dynamically. In this article, we will explore how to optimize asset allocation using the Dual Momentum strategy, incorporating current market trends to make informed decisions.
Understanding Asset Allocation in Dual Momentum
The foundation of the Dual Momentum strategy is built on two types of momentum: relative momentum and absolute momentum. Relative momentum compares the performance of different asset classes, identifying the top performers, while absolute momentum determines whether an asset is worth holding based on its performance relative to a risk-free asset like cash or short-term bonds.
In practice, this means that at any given time, your portfolio will be allocated to one of three options:
- U.S. stocks (or a similar equity index).
- International stocks (non-U.S. equities).
- Bonds (as a safe-haven asset during periods of market stress).
Current Market Conditions: September 2024
As of September 2024, global markets have been experiencing increased volatility. Inflationary pressures in major economies and geopolitical uncertainty have led to concerns about a potential recession. Interest rates have been rising in response to inflation, which has impacted bond prices, while the equity markets have been fluctuating as investors reassess risk.
These conditions make it a perfect time to analyze how the Dual Momentum strategy can help navigate through this uncertain environment by dynamically shifting between asset classes based on market performance.
Applying Dual Momentum to Current Markets
Let’s take a look at how you can apply the Dual Momentum strategy to optimize your asset allocation based on current market trends.
1. Relative Momentum: U.S. Stocks vs. International Stocks
In September 2024, U.S. stocks, as represented by the S&P 500, have seen a modest recovery after a turbulent summer, with year-to-date returns of around 7%. On the other hand, international stocks, as represented by the MSCI ACWI ex-U.S., have lagged behind, returning only 3% during the same period.
By applying relative momentum, we can see that U.S. equities have been outperforming their international counterparts over the past 6 to 12 months. This suggests that, for now, the portfolio should tilt more heavily toward U.S. stocks. However, relative momentum alone doesn’t tell the full story.
2. Absolute Momentum: Bonds as a Safe Haven
While stocks have seen some positive momentum, it’s crucial to consider the broader macroeconomic risks. Rising interest rates have led to declines in bond prices, with the Bloomberg U.S. Aggregate Bond Index down approximately 5% for the year.
However, in periods of heightened volatility, absolute momentum can act as a safeguard. If equity markets were to experience another sharp downturn, the Dual Momentum strategy would suggest shifting from equities to bonds or cash, depending on the performance of bonds relative to risk-free assets.
Based on absolute momentum signals, bonds have not yet shown enough positive momentum to be favored over equities. But if inflation continues to rise and equity markets start to falter, bonds or cash could become the preferred asset class.
3. Combining Relative and Absolute Momentum
When combining both momentum signals, it’s clear that for now, U.S. stocks should remain the dominant asset class in the portfolio. However, this could change quickly if market conditions deteriorate further. Given that international stocks have lagged behind U.S. equities and bonds have not yet demonstrated sufficient absolute momentum, the current portfolio allocation would likely look something like this:
- 70% U.S. stocks
- 10% international stocks
- 20% bonds or cash
This allocation reflects the current dominance of U.S. equities based on relative momentum while maintaining a defensive position with a modest allocation to bonds or cash in case of further volatility.
Adjusting Allocations Based on New Data
The beauty of the Dual Momentum strategy is that it adjusts dynamically to new information. As market conditions evolve, your portfolio should, too. Here are some key events to watch for that may signal a need to adjust your asset allocation:
- Shifts in Interest Rates: Rising interest rates can further pressure bond prices, making them less attractive. On the other hand, if inflationary pressures subside and rates stabilize, bonds could become a safe haven for investors seeking to reduce risk.
- Corporate Earnings Reports: Quarterly earnings reports from major U.S. and international corporations can provide insight into how the global economy is faring. If international stocks start to show stronger earnings growth, relative momentum may shift in their favor.
- Geopolitical Events: Geopolitical risks, such as tensions in trade or international conflicts, can impact both equities and bonds. Keeping an eye on how these events unfold can help you adjust your portfolio quickly if needed.
Risk Management with Dual Momentum
One of the key advantages of Dual Momentum is its built-in risk management feature. Absolute momentum ensures that you exit risky markets before losses become too large, while relative momentum keeps you invested in the best-performing assets. This approach helps to minimize drawdowns and protect capital during market downturns, which is particularly valuable in volatile periods like the current one.
For example, if U.S. equities were to experience a significant drop in momentum, absolute momentum would signal an exit into bonds or cash, helping you avoid a large drawdown. Similarly, if international stocks were to outperform U.S. stocks, relative momentum would guide a shift in allocation toward international equities.
Conclusion: A Dynamic Strategy for Changing Markets
The strength of the Dual Momentum strategy lies in its ability to adapt to ever-changing market conditions. In today’s volatile environment, optimizing your asset allocation using Dual Momentum allows you to take advantage of outperforming asset classes while managing risk through dynamic adjustments.
Currently, U.S. stocks are showing the strongest momentum, but as interest rates and inflation continue to fluctuate, it’s important to monitor absolute momentum signals to determine if bonds or cash become more attractive in the near future. By staying flexible and following the momentum signals, you can navigate the complexities of today’s markets and keep your portfolio on track.
In future articles, we’ll explore more specific case studies and dive deeper into how to use Dual Momentum across various asset classes. Stay tuned!