If you are going to bet on a horse race, would you rather pick the winning horse before the race begins or select a horse after they run the first straightaway?

A similar choice is made when playing the stock market. While some investors prefer to buy stocks before they begin to make a move, relative strength investors wait until a stock is moving higher before investing. The goal of relative strength investors is to buy high and sell higher.

Last week I wrote about style index rotation, where one rotates from large-cap to small-cap ETFs or from growth to value ETFs based on relative strength. But relative strength investing can also be used to reduce volatility in bear markets. By including an inverse ETF, ProShares Short S&P 500 (SH), our relative strength model will rotate to the inverse fund when that ETF is doing best (i.e. the market is falling).

This happened last year at the start of the pandemic. The model rotated to the inverse fund in early March after the market began to fall and was sold in mid-April once the market began its recovery. It wasn’t a profitable trade, but it really reduced volatility.

As the chart shows, the market (lower line) plunged 30% in March but a portfolio (upper line) that held two ETFs, one of which was an inverse fund, moved sideways. By year’s end the returns were fairly similar but rotating to the inverse fund greatly reduced volatility.

The mechanical trading model I’m using is found in my 2011 book, Exchange Traded Profits. This book is available at Washoe County libraries. Free relative strength rankings including inverse funds are updated each weekend at http://www.etftradingstrategies.com/analysis.htm.

This analysis provides a good example of what often happens when you jump into and out of the market. It’s very hard to improve returns over simply buying-and-holding but volatility is reduced.

David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.