Frequently Asked Questions
I've heard timing systems sound great, but performance figures are based on theoretical models that are tuned to historical data. In reality, they switch too often. And they have to be right twice: getting out of the market and getting back in. And they don't beat buy and hold. Right?
Yes, many timing systems
are guilty on all counts. Historical data are used because it gives us a means
to discover patterns and relationships that affect investment performance. The trick
is to generalize as much as possible, so that future patterns are recognized
when similar to past patterns and adaptable when not. The work reported in the Hulbert
Financial Digest, the popular chronicler of market timers, shows that the
top-performing timing services just about match a buy and hold strategy, but at
much lower risk (less volatility).
Buying and holding is okay
in theory but dangerous in practice. In reality, few investors are capable of
buying and holding. Emotions get in the way of needed analysis and discipline.
Panic selling and comfortable buying usually lead to selling low and buying
high. Moreover, I'm not so sure that authentic buy-and-holders exist. Those who
decry timing are perhaps "closet" timers themselves. Examples include
raising cash by money managers, rebalancing portfolios among asset classes, and
buying and selling individual stocks, whether based on fundamentals,
technicals, rumors, tips, or whims.
A buy-and-hold strategy can
under-perform for long periods of time. For example, the stock market lost out
to both inflation and money markets over the ten years
spanned by the 1970s, yet the timing model's standard portfolio more than
doubled the market's performance. It can also decimate portfolios by the end of
a severe bear market, particularly if funds need to be withdrawn shortly
thereafter. The 20% declines in 1990 and 1998 and the 34% crash in 1987 were
followed by reasonably fast recoveries of capital for those who stayed
invested. But the 48% grind in 1973-1974 delayed new highs for seven years, as
did the 49% 2000-2002 bear market. The nearly three-year pounding starting with
the crash in 1929 devastated Dow-based portfolios by some 90%; it then took 25 years for the Dow to regain its former
high! The 2007-2008 bear market took the S&P 500 down by 52%. How
long will it take this Index to recover?
The buy-and-hold mantra
popularized during the remarkable super-bull market of the 1980s and 1990s was
shattered by the “lost” 2000 decade and its triple bear markets. Holding through severe down cycles postpones
dreams at best, shatters them at worst. And how about the
ulcers? Yet, long term, the stock market is the only game in town that
leads to financial well being (see Did
you know that...? below).
The déjà vu
markets are more
subtle and frustrating when misfortunate points in time are picked. The Dow hit
a high of 995 in 1966 and finally crossed 1000 six years later, with intervening
roller-coaster rides of down 22%, up 48%, down 36%, up 73%, and then... the
debacle of 1973-74. Once again the Dow sank below 1000... for
another six years into 1980. It then seesawed above and below 1000 for a couple
more years, bottoming at 777 in August, 1982, and not piercing above 1000 for
good until late that year. Imagine living as a buy-and-hold investor through
that grueling 16-year odyssey! How many did? We are currently living through a similar
performance with Dow 10,000.
The behavior of the market
over long periods is cyclical,
revealing sustained uptrends lasting months to years, followed by persistent,
but shorter, downtrends. The 1966-82 market was a shining example of
cyclical behavior, a timer's dream market. The period 1982-1990 also offered
persistent cycles, surrounding an increasing secular (long-term) trend, unlike
the flat trend of the earlier period. The 1990s market was unusually acyclical, with a steep uptrend.
Cyclical behavior is back during the current decade. Markets mirror our human
affairs, the push and pull of conflicted greed and fear. Markets are not random walks.
The timing
model's objective is to detect changes in these cycles as they
happen. It's not a model that tries to forecast the future level of the
S&P weeks or months ahead, a considerably difficult exercise that's been
largely unsuccessful in the literature with which I'm familiar. Rather,
it's a model that tries to identify cyclical inflection points, the tops and
bottoms of primary cycles, the points at which the market changes
direction. To be successful, a model does not have to be right twice, at
tops and bottoms, as critics maintain; it "just" needs to sell higher
than its buy points and buy lower than its sell points.
Have you heard this one
from the critics? If a timing system misses the best x weeks (or days,
months) over some investment horizon, its performance drops to about half that
of buying and holding, assuming its performance is the same as buying and holding
over the remaining weeks. Yes, true. But this view is decidedly
one-sided and self-serving; they fail to mention what happens if the timing
model avoids the worst x weeks, which after all, is a capital preservation
objective of all timing systems. Looking at the 1970-2008 time period,
investment performance drops by 52% should a timing system miss the 30 best weeks, while remaining invested the
rest of the time. Let's be self-serving
ourselves. If a timing system avoids the 30 worst weeks and remains invested the rest of the time, its
performance beats buy and hold by 59%. Ok, let's be fair. Suppose
the timing system misses the 30 best weeks but avoids the 30 worst weeks, while
remaining invested the rest of the time. Now, the timing system beats buy
and hold by 7%. In the final analysis, these exercises are simplistic and
futile, because (1) best and worst weeks are more likely to occur within
respective cyclical up and down trends, not randomly, and (2) cycle-aware
timing models are designed to detect these trends, not best or worst weeks per se.
|
Per Year Returns Basis S&P 500, with Reinvested Dividends |
|||
|
Period |
Buy and Hold |
Standard Timing Model |
Aggressive Timing Model |
|
1973-1982 |
6.6% |
14.0% |
13.1% |
|
1978-1987 |
15.2% |
21.0% |
23.0% |
|
1988-1997 |
18.1% |
19.8% |
26.0% |
|
1999-2008 |
-1.4% |
7.7% |
14.5% |
As the accompanying table
illustrates, both timing and the timing period are
everything. The standard timing model just beat buy and hold over the placid
(acyclical) 1988-97 period. The edge for timing was more decisive over
1978-87, a period that included a down 27% bear market over 21 months during
1980-82 and a 34% bear market that lasted four months in 1987. The models
trounced buy and hold during 1973-82, a span that housed the devastating
1973-74 bear that sliced portfolios nearly in half. The most recent ten
years includes three severe bear markets, once again giving the timing model a
capital-preservation advantage. Timing
models feed on cycles for sustenance.
The timing model has been live since the middle of 1989, out-performing buy and
holders through 2008, with much less risk. The 1990s ushered in an era of historically
low downside volatility, except for the brief near-bear markets in 1990 and
1998. It's nearly impossible for a timing model, indeed for anyone as the
records show, to beat buy and hold in markets that exhibit very little cyclical
behavior and no punishing downturns. The model's advantage clearly became
apparent during the 2000-2002 and 2007-2008 bear markets. And, to be
honest, the live implementation of a theoretical system rarely performs better
than its tested (theoretical) version.
Since 1990, the annually-revised live
models under-performed the current theoretical
model by about 4 percentage points per year. The question is: Does its use
improve my investment performance... and soothe my nerves? For me the answer is
yes, on both counts.
Just what is a bull or
bear market? And what’s the
difference between cyclical markets and secular markets?
Based on the commonly-cited 20% change to define cyclical bull and bear
markets, the S&P 500 printed 16 cyclical bear markets and 15 cyclical bull
markets (technically, we’re now in the 16th bull market) since
1929. The average bear lost 38% over 17 months, with half losing more than
34% in 17 months; the average bull gained 144% over 45 months; half
the gains exceeded 101% over 44 months. It’s not a
zero-sum game; it does pay to be in the market most (about 70%) of the time.
The bull-market high in March, 2000 was
followed by an 18-month 37% cyclical bear. This low was technically
followed by a lightening cyclical bull market that gained 21% over four months, ending in
January, 2002. Another cyclical bear
followed into October, 2002, ending a 9-month 34% cyclical bear decline, very close to the averages. The next cyclical bull market ran five years
into October, 2007, yielding a 101% gain. A 13-month bear market
followed, axing 52% from the index by November, 2008.
This was followed by the shortest bull market on record, a 24% surge over two months. Consistent
with recent volatility, the succeeding bear market shaved 28% over a record-short two
months. We’re in a 16th
bull market as of this writing, confirmed by a greater than 20% spike within
March, 2009.
Secular markets are not clearly defined, but do span multiple cyclical bull and bear markets.
A secular bear market is characterized by lower cycle highs and lower
cycle lows (a downwardly sloping M, the
opposite of a secular bull’s upwardly sloping W). The five-year secular bear
that ended in 1942 dropped 60%; the somewhat flat eight-year secular bear that
ended in 1974 shaved just 34%. The great
secular bull that started in 1974 ended in March, 2000, a record 26 years with
a stunning gain of 2353%, more than doubling the previous record gain from 1942
to 1966. The secular trend from 2000 to 2007 is flat, characterized by both new
cyclical highs and lows (Ms and Ws); the
view from 2000 to 2009 is that of a downward (bearish) secular trend.
Having said this, the model does not concern itself with
bull or bear markets per se; rather it strives to detect the beginning
of primary up or down trends of 10% or more over at least eight weeks. These primary trends do operate within the context of cyclical bull and bear markets. Primary uptrends are more likely within
cyclical bull markets, as primary downtrends are more likely within cyclical
bear markets. While it’s possible
to exploit a primary uptrend within a bear market, or a primary downtrend
within a bull market, experience with the model shows that it’s difficult
to do so. And that such counter-signals
are likely to be short-lived. During
secular bear markets, intermediate to long-term strategies should pretty much
remain in capital preservation (money market) modes. Eventually, patience will be rewarded with a
new bull market and the dry powder to exploit it. Hanging on to your money for future
deployment is, after all, the main benefit of a good timing system.
I'm unhappy with switching 100% into stocks at a buy signal, or into a money market at a sell signal. Does it have to be all or nothing?
No. If you're uncomfortable
with switching 100%, you could use a percentage that you can sleep with. For example, if you want to be 60% invested in stocks, move 60% of
your portfolio into stock funds or exchange traded funds (ETFs) at a buy
signal. If you always want to have at least 25% in stocks, keep that
amount in stock funds or ETFs during a sell signal. Or progressively shift
funds following a switch signal. For example, you could move some proportion
into stocks just after a buy signal. Then wait for a market pullback of, say, 3-5%
and move another portion into stocks. Alternatively, you could phase in a
switch, as in moving into cash in 25% chunks over four weeks. Also see
about diversification, next FAQ.
From Wikipedia: “An exchange-traded
fund (or ETF) is an investment vehicle traded on stock exchanges,
much like stocks. An ETF holds assets such as stocks or bonds and trades at
approximately the same price as the net asset value of its underlying assets
over the course of the trading day. Most ETFs track an index, such as the Dow
Jones Industrial Average or the S&P 500. ETFs may be attractive as
investments because of their low costs, tax efficiency, and stock-like
features. In a survey of investment professionals conducted in March 2008, 67%
called ETFs the most innovative investment vehicle of the last two decades and
60% reported that ETFs have fundamentally changed the way they construct
investment portfolios.”
You favor domestic stock ETFs and mutual funds. How about bonds, gold, commodities, foreign equities, and individual stocks?
Keep in mind that the
timing model addresses only the equity portion of a portfolio, which generally
should not be the entire
portfolio. It’s a good idea to
diversify portfolios with other asset classes such as bonds, precious metals,
commodities, international securities, and real estate. I primarily invest in ETFs consistent with
the model. But I also diversify by
including ETFs in bonds, gold, and certain commodities such as water. Diversification also includes investment
styles (value vs blend vs growth) and company sizes (large cap vs mid cap vs
small cap). The S&P 500, for example, would be classified as a large-cap
blend Index by Morningstar. If you wish to allocate 40% to assets other
than domestic stocks, then move up to 60% of your portfolio between stocks and
money market funds at switch signals.
To follow the standard
portfolio's stock investments suggests the use of an indexed mutual fund or
exchange traded fund (ETF) that tracks the S&P 500. Mutual fund families
such as Fidelity and Vanguard include menus of index funds. Another low-cost
alternative is to trade ETFs, such as Spiders (S&P 500 Depositary Receipts,
symbol SPY) through your broker, a derivative that mimics the S&P 500 and
"looks, sounds, and acts" like a stock.
By the way,
"domestic" funds and ETFs usually hold a fair percentage of offshore
stocks. Also, large domestic companies are multinational, and many other
companies profit from overseas economies, so there's actually a substantial
international exposure within most domestic stock ETFs and mutual funds.
It's also okay to use
individual stocks, but keep in mind that their price behavior can differ
substantially from the market's behavior. At a sell signal, you should consider
either dumping or reducing exposure to individual stocks, unless you have
reason to believe that they will swim upstream, or the tax consequences are too
much for you to "bear". Consider buying your favorite individual
stocks at a buy signal, because an up trending market is often favorable for
most stocks.
I would like to be more aggressive with some investments at buy and sell signals. What strategies are available?
At a sell signal,
aggressive portfolios might consider the purchase of mutual funds or exchange
traded funds (ETFs) that anticipate down markets. Mutual fund examples
include Bear ProFund (BRPIX),
At a buy signal,
ETFs that mimic our main indices include the previously mentioned DIA, SPY, and
QQQQ. Aggressive portfolios could invest in so-called high-beta funds.
For example, Potomac U.S. Plus (PSPLX) and Rydex Nova (RYNVX) have a beta of about 1.5, meaning that
their expected return is 50% better than the S&P 500 return in an up
market. The dark side of this flip is an expected 50% greater loss
in a down market! ETFs leveraged 200% include DDM for the Dow30, SSO for
the S&P500, and QLD for the Nasdaq 100.
Buying Spiders, Diamonds, or Nasdaq-100 Shares on margin are other
aggressive buy strategies. Even more aggressive alternatives include the
purchase of UltraBull ProFund
(ULPIX) and index call options.
These risky strategies can
turbo-charge returns, but should be exercised only by sophisticated investors
with high risk tolerances and cast-iron stomachs. They can do serious damage to
portfolios should the market go against the signal. The likelihood of loss
when trading options is high, even with reasonably good timing. Commitments to
these instruments should not exceed 5% of a portfolio.
The accompanying table summarizes
the simplest implementations of the model's standard and aggressive portfolios.
|
Portfolio Implementations |
|||
|
Signal |
Portfolio |
Position |
Invested Approximations |
|
Buy |
Standard |
100% long S&P 500 |
Any S&P 500 index fund, such as Fidelity's Spartan Market Index (FSMKX) or Vanguard Index Trust 500 (VFINX) SPY shares ( "spiders" ). * |
|
Aggressive |
150% long S&P 500 |
Potomac Rydex Nova Fund (RYNVX). * SSO shares (200% long position) |
|
|
Sell |
Standard |
100% T-Bills |
Any money market mutual fund that emphasizes Treasuries. |
|
Aggressive |
100% short S&P 500 |
Bear ProFund (BRPIX). * Rydex Ursa Fund (RYURX). * SH shares (100% short position) or SDSshares (200% short position) |
|
|
*Spiders are traded on the American Stock Exchange at a price that's approximately one-tenth that of the S&P 500 Index. Unlike most mutual funds, these are traded intraday. Rydex Funds are available either directly from Rydex (www.rydexfunds.com 800-820-0888) or through discount brokers such as Fidelity, Schwab, and Jack White. Ditto Potomac Funds (www.potomacfunds.com, 914-381-2080) and ProFunds (www.profunds.com, 888-776-3637). |
|||
|
Nova/Ursa Mixed Strategy |
|
|
Nova / Ursa Allocations |
Long S&P 500 |
|
0% / 100% |
-100% |
|
20% / 80% |
-50% |
|
40% / 60% |
0% |
|
60% / 40% |
50% |
|
80% / 20% |
100% |
|
100% / 0% |
150% |
Those investors who wish to be less aggressive within the Rydex-based
portfolio could mix allocations between the two funds, as seen in the table at right.
For example, an allocation of 80% Nova and 20% Ursa is equivalent to a 100% position in the S&P 500,
without reinvested dividends; 20% Nova and 80% Ursa is equivalent to a 50% short position. Note that the
40%/60% allocation is market neutral, a position that's
equivalent to cash under the mattress, but with a bias in the direction of the
market trend in an asset-allocation sense. The same goes for using the
Potomac-Funds and ProFund equivalents. Similar
calculations are possible with the ETFs mentioned earlier. For example, 50% in SPY and 50% in SH would
be market neutral for the S&P 500, as would 50% in SSO and 50% in SDS.
NOTE: Important advantages of ETFs over mutual funds are no restrictions on
number of trades and the ability to trade at any time of the day.
I'm not sure how to interpret the terms "Annualized", "Years to Double", and "Risk" in the performance comparisons?
The label
"Annualized" or "Per Yr Return" is the annualized return
from the beginning to the ending year. It's the annual compound rate that would
give the ending amounts over the given time horizon. For example, a return of
40% in the first year and a loss of 10% in the second year is equivalent to an
annualized return of about 12.2%. If we were to apply the 12.2% rate over each
of two years, we would end up with the same amount of money as if we had used
40% one year and -10% the other year. Note that the annualized rate is not a
simple average!
The term "Years to
Double" is the number of years it would take to double an investment for
the given annualized return. It's an alternative measure of performance that's
easy to relate to: "Now let's see, if I park my money in a money market
with returns equivalent to T-Bills and the average performance over the 1990s is
repeated, my investment should double in about 15 years. Uhmm..."
The label "Risk"
is an attempt to quantify a rather illusory and subjective concept. By my
definition, risk is incurred if I can't beat the return on cash, where T-Bills
serve as the proxy for cash or money markets; it's the average deviation
between a position's return and the corresponding year's T-Bill return for
those returns that under performed T-Bill returns. For example, suppose that
over a two-year period T-Bills return 4% and 5%. Over the same two years,
investment A gains 20% and loses 10%, while investment B shows returns of 10%
and 50%. The average risk for A is 7.5% (the sum of 0 in the 1st year and 15%
in the 2nd year divided by 2 years) and the average risk for B is 0% (it outperformed
the cash alternative in each year). Investment A is showing risk because it
under performed the "riskless" cash
alternative in one of those years, whereas investment B did not exhibit this
type of risk over those two years. Interestingly, the traditional quantitative
measure of risk (standard deviation of returns) would show that B is more
"risky" than A (it's more volatile). I'll take upside volatility
anytime. It's downside volatility that I want to avoid! By the way, this
measure of risk is conceptually the same as that used by Morningstar.
Why is your service free? Do you plan to charge in the future?
It's been a free service
since 1995 more because of time constraints and other commitments than
anything. My university faculty job was full time, the market timing modeling
work was part of my research function, and the free site was part of my service
function. It did serve to establish a public record, it's been consistent with
the original (free) spirit of the Internet among researchers, and it's been
fun. I retired in June 2007, cruised and lived on my boat until recently, and
am currently deciding whether or not to fee-base the service.
Did you know that... ?
Since 1926, a money market
investment based on T-Bills would have earned about 3.7% per year, barely
edging out inflation at 3.0%. Long-term cash investments are like bad dreams
where you run in place. They're the slow boat to poverty. Long government bonds
haven't been so hot either, at about 5.7% annually. But the S&P 500, with
reinvested dividends, clocked in at 9.6%, a wealth building real
(inflation-aware) difference. In plain dollars, Rip-van-Winkling one thousand
bucks into T-bills in 1926 would give about $20 thousand for today's wakeup
present. Pretty shabby, especially considering that it takes about $12,000
today to buy the equivalent of $1000 then. But stocks looked good in the
Roaring 20s. If Rip had placed the money in stocks, the wakeup fund would have
grown to an eye-popping $2 million. Rip's dreams came to pass... but do we have
that much time? And do we remain oblivious to market volatility... as Rip
surely did and buy and holders must?
Last revised 03/28/2009
Distribution
Copyright © 2009 Richard Mojena. All rights reserved. The information presented here may not
under any circumstances be resold or redistributed for compensation of any kind
without prior written permission from Richard Mojena at mojena.com.
Disclaimer
Specific and personalized investment advice is not intended by this
communication. Its contents are for the public record as a free public service.
Information is based on the analysis of past data and assessments by the
models. Future performance may not reflect past performance. Profitable trades
are not guaranteed. No system or methodology ensures stock market profits. No
guarantee is made regarding the reliability or accuracy of data. In other
words, use this stuff at your own risk!