The Independent Market Observer

1/23/14 – The Return of Market Timing?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 23, 2014 6:27:37 AM

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In the last several posts, we’ve talked about two problems. The first is that drawdowns—which is to say, losses—is a better risk measure for most investors, and something to be avoided. Portfolios should therefore be designed to avoid drawdowns as much as possible. The second problem is that market valuations are very high right now, which both raises the risk of drawdowns (back to point 1) and also makes it very likely that future returns will be below what most people expect.

Stepping back a bit, what both of these points address is the problem of terminal failure—that is, of simply not achieving your investment goals at the end of whatever your target time period is. Drawdowns can make an investor unwilling to take enough risk to reach his or her goal, while returns below expectations may also mean the goal isn’t met, even if the investor is willing to bear the risk. This is the real problem we face as investors and advisors: taking enough risk to meet our goals, but making sure that our expectations will be met in return for taking that risk.

In theory, market timing would provide a solution to both of these problems, by limiting the losses and preserving the returns. It would get in while the market was rising and out while it was falling—but before the bottom fell out. Nice work if you can get it.

The reality is that no one can time the market. This is a different statement, though, than saying there are no rules investors can use to increase their chances of positive outcomes and reduce their chances of losses. Such rules do exist, and can work, but there’s a cost: lower returns in a rising market. Given that, until recently, the market had been rising over the past several decades, it’s no wonder market timing acquired a bad reputation. Over the last decade, however, the market hasn’t risen in the same way as in the past, which raises the question of whether market timing might be worth another look.

That brings us to a research study I did several years ago, to answer several questions. Does market timing work? If so, what does “work” mean in this context? Are there times when it adds value? At what cost?

I approached this by looking at the U.S. stock market, specifically the S&P 500, over the 40-year period from 1970 to 2009. I deliberately used a very simple trading strategy, where an investor was in the market if the market was over a 200-day moving average, and in cash otherwise. I then analyzed the performance of the strategy as compared with buying and holding the S&P 500 for various calendar time periods.

Let me be very clear: this was not intended to be a real strategy, and I’m not suggesting that anyone use it. It is meant as a thought experiment to determine what the effects of such a strategy might be. It can also serve as a benchmark for other, more complicated and realistic tactical strategies, but that’s a different discussion.

The results were interesting, and generally as expected. Buy-and-hold (BAH) generated higher average returns over most time periods, showing that (at least for these time periods) BAH did make sense for investors with a long time horizon. From a risk-management perspective, though, the tactical approach (TAC) resulted in much lower variability of returns, as well as higher returns when adjusted for that risk.

More to the points we’ve been discussing here, the TAC approach showed superior minimum average annual returns over multi-year periods. For 10-year holding periods, for example, the lowest return for BAH was −3.4 percent per year, while the lowest annual average return for TAC for a 10-year hold was 4.6 percent. For investors with a 10-year time horizon, that’s the difference between potential success and certain failure. Drawdown risk was also cut by almost half, with the maximum drawdown for a BAH portfolio at over 50 percent and the maximum drawdown for a TAC portfolio at just over 26 percent.

The results varied significantly from decade to decade, though, which raised the question of why. Why in some periods did it pay to take a tactical approach, while in others buy-and-hold was the way to go? To what should be no one’s surprise, given the previous posts here, the difference turned out to be the initial valuation of the market as a whole. The higher the initial valuation, the more value a tactical approach added. These results suggest that, as markets get more expensive, the value of being able and willing to get out goes up.

I also ran what I called a “metatactical” model, which combined the two approaches. When the market was cheap, the model bought and held; when the market got expensive, the model switched to tactical. This proved very successful at preserving most of the upside exposure and risk reduction, suggesting that a middle way is probably the best.

These models have drawbacks—trading costs and taxes being two of the most obvious—and, again, I’m not recommending them as an investment strategy. But, at times like the present, when the market is richly valued, they do serve to show that caution and attention to the downside risk are warranted. A long-term commitment to the equity markets is necessary for investors to meet their goals, but attention to the risks, and comparison of history with current expectations, is equally important.

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