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 often 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a severe bear market, particularly if funds need to be withdrawn shortly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 1973-74 delayed new highs for seven years. 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! And, at six
years and counting, the jury is still out on a recovery from the 2000-2002 bear
market, which pounded the Nasdaq by 78% and the
S&P by 49%. 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?
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 was back in 2000-2002. 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 1970-2007
time period, investment performance drops by 44% 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 48%. 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 4%, essentially a dead heat. 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 |
|
1973-82 |
6.6% |
14.0% |
13.1% |
|
1978-87 |
15.2% |
21.0% |
23.0% |
|
1988-97 |
18.1% |
19.8% |
26.0% |
|
1998-07 |
5.9% |
10.7% |
29.2% |
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 also included a severe bear market, 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 2007, 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 was
more decisive during the 2000-2002 bear market. 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 3 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 fourteen cyclical bear markets and thirteen
cyclical bull markets (technically, we’re now in the 14th)
since 1929. The average bear lost 39% over 20 months; the average bull gained 157% over 48 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 three 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 current cyclical bull
market followed, which as of this writing (June 2, 2007), stands 98% above the
October, 2002 low.
We ended the third secular or long-term bear market since 1929 in October of 2002. This confirmation was established on May 30,
2007 as the S&P 500 broke out to a new all-time high above the previous
all-time high established in March, 2000.
Secular bear markets span multiple cyclical bull and bear markets,
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 most recent secular bear
posted a 49% loss from March, 2000 to October, 2002. By secular standards it was short at nearly 2
½ years and included a short cyclical bull market wedged between two cyclical
bear markets.
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 just 70% invested in stocks, move
70% of your portfolio into stock funds at a buy signal. If you always
want to have at least 25% in stocks, keep that amount in stock funds during a
sell signal. Or progressively shift funds following a switch signal. For
example, you could move some proportion into stock funds 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.
You favor domestic stock mutual funds. How about bond funds, gold, foreign funds, and individual stocks?
Include assets such as
bonds, precious metals, international securities, and real estate in your
portfolios if you wish. The timing system doesn't deal with these asset
classes. To strictly follow the standard portfolio's stock investments suggests
the use of an indexed mutual fund that tracks the S&P 500. These are
available through mutual fund families such as Fidelity and Vanguard. Another
low-cost alternative is to buy 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.
I mostly invest in S&P
500 funds and some aggressive variations, but a more conservative strategy is
to use a variety of domestic mutual funds, to diversify with respect to asset
classes based on investment styles (value vs blend vs growth) and company sizes
(large cap vs mid cap vs small cap). An index fund based on the S&P 500, for
example, would be classified as a large-cap blend fund by Morningstar.
But if you like to allocate 40% to assets other than domestic stocks, then just
move 60% of your portfolio between stock and money market funds at switch
signals.
By the way,
"domestic" funds 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 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 that
anticipate down markets. Examples include Bear ProFund
(BRPIX),
At a buy signal,
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! 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). Shares of Standard & Poor's Depositary Receipts, "spiders" (SPY). * |
|
Aggressive |
150% long S&P 500 |
Potomac Rydex Nova Fund (RYNVX). * Shares of Spiders on margin. |
|
|
Sell |
Standard |
100% T-Bills |
Any money market mutual fund. |
|
Aggressive |
100% short S&P 500 |
Bear ProFund (BRPIX). * Rydex Ursa Fund (RYURX). * Sell short Spiders. |
|
|
*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.
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, and am now cruising/living
on my boat full time for several years... If feasible, I will likely continue
the site during that time... then I'll decide whether or not to fee-base the
service, either on my own or possibly in collaboration with an existing,
established financial services firm.
Did you know that... ?
Since the birth of the
S&P 500 in 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 5.6%
annually. But the S&P 500, with reinvested dividends, clocked in at 10.3%,
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 $3.2 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 01/30/2008
Distribution
Copyright © 2008 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!