There has been a lot of discussion about market timing in the past, but frankly most systems are too complicated to use for the average person. Plus, though all timing systems work in backtest, many fail in real life.So what's a person to do?Herewith, a really dumb, simple timing system that gives only one signalper year on average, and reliably improves risk adjusted returns.It's aimed at the broad market buy-and-hold crowd, with the goal ofjust a little bit better sleep during bear markets. But, I find it'sa very good simple bear market detector for more sophisticated uses too.From a free investment newsletter I write.Jim=======================================================================The Informed Hunch, your free investment rag"Words are cheap, especially ours!"Executive summary: beat the market with 2/3 the riskand only one simply determined trade per year on average.Now you can decide if you want to keep reading!You may have noticed that it has been a fairly excitingmonth, quarter, and year in the stock markets. But, in orderto resist confusing the trees for the forest, let's start withthe broad view. In short, if you hold stock and aren't buyingmuch more right away, it's annoying when the stock you owngoes down in price for a long time. This is a quick discussion about bear markets, aimed at thosefolks who don't think it's very worthwhile trying to beat the market,and yet---and yet---discover that bear markets are no fun.If you think that an index fund is the height of sophistication,and really aren't into working hard picking individual stocks,then read on. There might just be a way to do just a tiny bit better.My starting point was the following ideas:- There is no doubt that bull and bear markets exist. Sometimesthe market goes roughly upwards for several year, and sometimesit goes roughly downwards for several years.- The sort of folks who use index funds are not the sort offolks that are interested in sophisticated daily trading systems.So, if we're going to improve on things, it had better be simple.So, lets start with the basic idea that we'd like to be in the stockmarket when it's going up, we want to be out of the stock marketwhen it's going down, and we don't want to switch between thetwo all of the time. This method has a signal about once ayear on average, which isn't exactly "active" trading.What is a rising market? Obviously prices don't go up every day,they go up in a zig-zag. The main property of a rising market isthat the zigs and zags get higher on a fairly steady basis.Thus, we have a workable definition of a bull market: theprice of stocks is hitting new recent highs fairly regularly, withnot too long a gap between them. Conversely, a bear market iswhen this isn't true: no recent high has been made in the last while.So, how "recent" is a recent high? and how long should wewait before calling it a bear market? And, why would this help?Let's start with the last question. My theory is that wheneverthe US stock market hits a new recent high on the index whichis most watched, it has a reinforcing effect of pleasure on thegreed portion of the brain. People will tend to want to investfor a while, but then the buzz will wear off and they'll needanother dose to keep their greed active. Without thatreinforcement, they gradually become fearful and startwanting to get out of the stock market, which is of coursethe sentiment that generally causes falling stock prices.But, whether this theory is true or not, certainly our definitionof a rising market is pretty simple: higher recent highs.Or, put in reverse, a bear market is when we haven'tset a new recent high in quite a while.So, I looked at a graph of the US stock market. Themain zigs and zags are reasonably short duration, so itappears that if you go 100 trading days (around five months)without a new recent high, it's a worrying sign. Lookingat those times on the graph, nobody would describe it as a steadilyrising market, and that's likely to get people worried.So, we have a tentative definition of a bull market: if a bear marketis when we have gone 100 days or more without a new recent high,then a bullish time is when market has hit a new recent high in thelast 99 trading days or less. Well, we haven't defined "recent" high,so for the sake of simplicity, I'll use the same 99 trading days.We're more or less assuming that the investing populationrarely has a memory more than five months long!This gives rise to our signal.Imagine a graph of the US stock market. Most investorsfollow the S&P 500 these days, though in the early partof the century the Dow Jones Industrial Average was thefashionable thing. I'll stick with the S&P 500 for the firstpart of the discussion.Now, overlay on that graph a line which represents thehighest daily high price in the last 99 days. This sortof skims across the top of the market price, then falls offafter a while if it doesn't get pushed upwards again.The signal is simple: if the last change in that line wasupwards, stay in the stock market. If the last change inthat line was downwards, sell all your stock and hold cash.(for cash, I'll assume the usual choice of investors is3 month treasury bills). Pretty simple.So, how well does this do?We want higher returns and lower risk. But, we have todefine our terms. I have a boring appendix* on how I calculatedthese at the end of this message. But basically thereturns are the annual compounded average, and the riskis a single number where 0% is perfect and 15% is really bad.Since 1930, had you invested in the S&P 500 index and receivedall the dividends from those companies and reinvested them,you would have made a return of 9.51% per year compounded.However, it would have been a very rough ride. My overall riskmetric comes out to 11.80%. Is that a good number? No.Zero is a zero risk result on this metric: something that madea perfectly steady 10.0% per year compounded. A risk scoreof 2% would be a really nice hedge fund, around 5% would bevery steady returns, and over 15% is the sort of thingyou get investing in internet bubbles.By using the rule that I described above, you would have hada total return of 11.80%, with a total risk of 6.71%. So, youwould have had 2.3% per year higher returns on average,while experiencing only about 56.9% of the risk (because 6.71/11.80 = .569).Higher returns, lower risk. That sounds good, right?But, is this one of those iffy timing systems that really only worksbecause it managed to avoid the crash of 1987 of something?No, actually it has you in the market in the 1987 crash: it'snot perfect. But does it really add value on average through the years?Not always, but pretty darned well. Sometimes you do a little worse,but never a lot worse. And when you do better, you do a LOT better.So, overall, it's worth it. Here is a table of returns for different five years periods.Period S&P 500 Switching Improvement 1930-1935 -12.2% 4.3% 16.4% 1935-1940 10.3% 16.2% 6.0% 1940-1945 7.4% 5.6% -1.8% 1945-1950 10.2% 7.4% -2.8% 1950-1955 23.6% 22.5% -1.1% 1955-1960 15.2% 13.8% -1.4% 1960-1965 10.7% 11.7% 1.0% 1965-1970 5.0% 7.1% 2.2% 1970-1975 -2.4% 6.8% 9.2% 1975-1980 14.8% 12.0% -2.8% 1980-1985 14.8% 20.1% 5.2% 1985-1990 20.4% 18.8% -1.7% 1990-1995 8.7% 6.7% -2.0% 1995-2000 28.6% 27.9% -0.7% 2000-2005 -2.3% 4.3% 6.6% 2005- 2.0% 4.5% 2.5% At first glance, it doesn't seem to improve things a whole lot.But, look at how steady the returns are. For example, note that five-year periods that things get worse are onlyworse by -1.8% on average, while the periods that thingsare better are better by +6.2% on average. Also, notethat the times that things get worse, you're still doing very well. The average return during a 12 month period that thesystem "didn't work" (returns were lower than just holding the S&P)are still actually above average at +12.41% per year including dividends.So, in short, on average you're giving up a little bit of return inthe very good years but gaining a very large amount of returnin the very bad years, for a small net gain in returns anda very large net gain in steadiness. As one very simple measureof steadiness, the standard deviation of rolling-year returns is14.9% instead of 19.8%, and with a higher average.(a standard deviation of zero would indicate perfect steady returns).Overall, the system is in the market 73.9% of the time,and has just over one signal per year on average (1.02, actually).So, although it can not save you from a totally randomunpredictable market crash, it could save you from some of them,since you'll be in cash over a quarter of the time.Any crash that happens while you're holding cash is notgoing to hurt you. Plus, of course, you are out of the marketfor a large part of any long decline. The longer it lasts,the more of it you miss, which is why the system worksto ensure you don't have a really bad few years.Of course, it would be nice to test the system a bit further.The Dow Jones Industrials index is older, and I was ableto test it before 1930. It seemed to work just fine:For 1900-1929, the average return while it said to be in the market was+8.1% per year (not counting dividends), and the average market returnwhen it said to be in cash was -0.8% per year.From 1930 to 1949, "buy" periods returned +3.5%, andthe market returned -9.0% per year in the "cash" periods.From 1950 to 1969, "buy" periods returned +9.5%, andthe market returned -0.5% per year in the "cash" periods.From 1970 to date, "buy" periods returned +8.3%, andthe market returned +2.8% per year in the "cash" periods.This is a nice confirmation, but I recommend using theS&P 500 "daily high" values.All of these numbers are pretty confusing, so here are a coupleof nice pictures to convey the message simply.Here is a graph of the S&P 500 index including dividendssince 1930 (the lower line), compared to the money you would have ifyou had followed this system (the upper line).http://www.stonewellfunds.com/BearSignalLongTerm.jpgGreen is "in the market", red is "what the market did during periodsthe system recommended cash", yellow is the times of cash returns,and the hot pink line is the "99 day high" line that determinesif you are in the market (pink rising) or not (pink falling).Sorry for the tiny text, but it's a long history to get into one pic!Which line would you like your portfolio to be?Here's what the last couple of years looks like graphically:http://www.stonewellfunds.com/BearSignalShortTerm.jpgThis only shows the S&P index, not the portfolio whichalso gets out of the market. It simply colour-codes the indexbased on the system's signals: green for "buy", andred for "cash". The yellow line is the "99 day high"signal line. You can see how it works: if the last movein the yellow line was upwards, the index is green becauseyou should stay in the market. If the line's last movement isdownwards, the index is shown in red because it's time to go to cash.The system had you in the market for a long time (sinceNovember 4 2004), then triggered a move to cash on March 5th2008 after a gain of 24.1%. Obviously it wouldhave been better to trigger it earlier (nearer the market top lastfall), or later (after the bounce in May), but the main point is thelong run. Even though it picked a poor week to go to cash,the market has gone down another 9.1% since then---a loss thatthis system avoided---so over the longer cycle it seems to have it right.In fact this cash period is now guaranteed to be profitable, since the"99 day high" line is below the point that we left the market---we will getback in again lower than where we got out in May, though wedon't yet know when that will be, so we will definitely be aheadof the people who stayed in the market the whole time.Note that you don't have to calculate this every day.The last point in red is last Friday's close. If the marketrises above the yellow "99 day high" line at any timein the next while, we'll know it's time to get back intothe market. We know pretty much what that line lookslike for quite a while into the future. Plus, once it is backin the market, it is guaranteed to stay there for at least100 days, so that's 100 days that you don't have to even look.Now, I admit that this is not a very sophisticated signal.But, it has the huge benefit of simplicity, and extremelyfew signals to pay attention to. Every time you hit a newrecent high, you're guaranteed to be in the market forthe next several months, and even in times of cashlike now, you know about where the market will haveto go in future for you to have to look more closely.Right now it's extremely unlikely that this system willrecommend the stock market before the middle ofNovember, and even then it will have to rise at least8.25% from here for that to happen.What about the choice of 100 days? Is that selectedwith hindsight? Yes, of course it is. But all sorts ofdifferent numbers work just fine to reduce risk andgive quite reasonable returns. Only the numbers around100 days actually improve average returns a bit, though allkinds of numbers from 60 days to 120 days willimprove risk-adjusted returns quite a bit. In other words,even if you use the "wrong" number the worst you're likely toexperience is a small reduction in long run average returnsin return for a large reduction in risk.Will it keep working? No, not every year. Some yearsyou'll be a couple of percent worse off. But, you'll sleepmuch better, and you will take pity on your friends whoblindly stay in the market all through those nasty bear periodslike this year. There is a big difference between nevertrading, and standing on the sidelines just occasionallywhen things are going steadily downwards.Happy investing!Jim* Appendix: how the risk and return numbers were calculated.Feel free to skip this paragraph---I'm justdescribing how I measure risk and returns, so you'll knowwhat I mean by "risk". For returns I'll use the usual compoundannual rate of return including interest and dividends.The "long term buy and hold" approach has dividends all thetime, and never any interest. The "switching" approach hasdividends when it's in the market, and interest otherwise.There is no provision for income tax in either scenario.For risk, I use a metric called a downside deviation.This is based on the ideas that (1) you really want to makea certain amount of money every single year---I assumed10% per year, (2) that any twelve month period which is lowerthan that is a "failure" because it had a shortfall from your goal, and (3) that a shortfall of twice as much is four times as bad. i.e., getting 2% return (which is 8% less than your 10% per year goal) is four timesas bad as getting a 6% return (which is a shortfall of only 4%).So, each doubling of the shortfall from your goal is given four times the penalty.You can ignore the details, but what it means is that I'vecome up with a single number representing risk: it's theaverage of the penalties from (a) 3 month periods that didn'teven break even, from (b) 1 year periods that didn't make 10%,and from (c) 2 year periods that didn't make 21% (which is 10%per year compounded).
Period S&P 500 Switching Improvement 1930-1935 -12.2% 4.3% 16.4% 1935-1940 10.3% 16.2% 6.0% 1940-1945 7.4% 5.6% -1.8% 1945-1950 10.2% 7.4% -2.8% 1950-1955 23.6% 22.5% -1.1% 1955-1960 15.2% 13.8% -1.4% 1960-1965 10.7% 11.7% 1.0% 1965-1970 5.0% 7.1% 2.2% 1970-1975 -2.4% 6.8% 9.2% 1975-1980 14.8% 12.0% -2.8% 1980-1985 14.8% 20.1% 5.2% 1985-1990 20.4% 18.8% -1.7% 1990-1995 8.7% 6.7% -2.0% 1995-2000 28.6% 27.9% -0.7% 2000-2005 -2.3% 4.3% 6.6% 2005- 2.0% 4.5% 2.5%
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