Monthly Momentum in S&P 500 and Treasury Bonds (Bond Rotation Strategy in SPY and TLT)

TLT vs SPY – Bond Rotation Strategy. Some days ago we published an ETF rotation strategy that rotates between SPY, TLT, and EEM based on monthly momentum. Today we look at a similar ETF sector momentum/rotation strategy but we exclude EEM: A SPY and TLT strategy (S&P 500 and 20 years Treasury bond).

The SPY and TLT rotation trading strategy might work well because TLT often works as a safe haven when the stock market is weak. Below you find the logic and code for this simple SPY and TLT momentum/rotation strategy. The drawdown is low but the total return is better than “buy and hold”. 

What is momentum and how has it performed?

Momentum is a well-known strategy that has performed well for many decades. It doesn’t work on long timeframes, but best on semi-long timeframes from 1 to 12 months.

For example, one strategy that has performed well is to buy the stocks that have performed the best over the last six months. At the end of every month, you rank the best stocks and buy the best x stocks and hold them for one month. At the end of next month, you rank again. Rinse and repeat every month going forward.

The only drawbacks with momentum strategies are big drawdowns and survivorship bias:

• How to deal with drawdowns
• Survivorship bias in backtesting, trading, and investing

What is sector rotation?

Sector rotation is changing assets tactically when you sell one asset and buy another one. Switching between SPY and TLT is a perfect example of sector rotation. Frequently, sector rotation is based on momentum strategies.

Trends come and go. However, it’s difficult to predict which asset classes perform the best in the future. Hence, many define strict rule-based trading purely based on quantitative rules, exactly what this website is all about. Below you find our test on monthly rebalancing between SPY and TLT based on the best performance the prior month.

Why should sector rotation between SPY and TLT work?

S&P 500 and Treasury bonds are frequently mentioned as a tactical asset allocation strategy based on momentum and rotation. Why is that?

The most likely explanation is this:

Treasury bonds are often a safe haven. When the future is uncertain many investors seek to allocate more to assets like Treasuries. The relationship tends to last a few months. This is why this type of sector rotation is so popular.

Is sector rotation and momentum a hedge against tail risk?

Nassim Taleb became famous for his thoughts about randomness and tail risk. Because tail risk increases chances of bankruptcy and behavioral mistakes, both traders and investors should have tail risk in the back of their heads all the time:

• Tail risk hedging strategies
• Negatively skewed trading strategies

As it turns out, please see the chart below, the rotation between the S&P 500 and Treasury bonds has produced slightly better returns than holding the S&P 500, but at the same time had substantially less drawdowns. Thus, we can argue this strategy is a hedge against tail-risk, but it’s, of course, no guarantee this will repeat in the future.

Testing momentum/rotation between SPY (S&P 500) and TLT (Treasury bonds):

Let’s test how this strategy performs when rotating between SPY and TLT. We make the following trading rules:

Trading Rules

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