The Best Way to Time the Market | White Coat Investor

You’ve heard it before –

“You can’t time the market.”

“Time IN the market matters more than timing the market.”

“Nobody has a working crystal ball.”

“The only value of stock forecasters is to make fortune-tellers look good.”

It’s part of Investing 101, and it’s very important that you understand why market timing is generally a futile exercise. We are naturally emotional creatures who constantly flip back and forth between greed (aka Fear of Missing Out) and fear, which causes us to constantly buy high and sell low, incurring transaction costs and taxes all the while. Following a written, systematic, buy and hold approach is a great way to beat our own emotions and achieve investing success.

However, in teaching those extremely important principles to investing beginners, we fudge the truth a little bit. You see, the truth is that market timing has worked in the past and that it did NOT require a crystal ball to be successful. Today, I’m going to discuss how the market can be successfully timed. I’ll describe not only what I mean by “successful” (because it’s probably not what you think) and also tell you exactly how to do it.

 

Trend-Following

So here’s how you do it. You use a Simple Moving Average (SMA). When the price of stocks (preferably using a broadly-diversified, low-cost index fund) goes above the SMA, you buy. When it goes below the SMA, you sell. What is the SMA exactly? It is the average of the price of that fund over the last time period. Common time periods are 10 days, 50 days, 100 days, 150 days, and 200 days. The longer the time period, the more of a downturn you capture before selling and the less of an upturn you capture before buying, but the less frequently you are “whipsawed” (i.e. buying just before it goes back down and selling just before it goes back up) and the less frequently you pay for the transaction (in commissions, bid-ask spreads, taxes, and the value of your time). The nice thing about this technique is that it doesn’t require you to know anything about the future, just the past. Nor is there anything complicated or emotional about it. It can be done very rationally and automatically.

So here’s what the chart might look like. You can see where the technique is successful and where it is not. The idea is to be in while the market is rising and out while it is falling. You can see in 2000 there were a bunch of times that getting out when the trend fell below the average was the wrong move (since it then rapidly went up.) But you can also see that it had you out of the market for a good chunk of the downturn in 2001-2002. That had to be beneficial to returns, no? And you got back in before it went up too much in 2003. Then you can see a bunch of whipsawing in 2004-2006, which isn’t good, but then the system had you out for most of the 2008-2009 crash. Again, you got whipsawed a few times in 2010-2012, but mostly you were in for the bull market.

So the question is how does following the Simple Moving Average stack up against buying and holding? Well, the honest truth is it wins. And it loses. What? Let me explain.

 

Returns vs Risk-Adjusted Returns

While the data is all period-specific, in general, you will find that a trend-following technique like this has lower returns than a simple buy and hold portfolio. It just doesn’t work well enough to give you higher returns, despite avoiding a good chunk of the major crashes. Take a look:

This data comes from ETFreplay.com, but it looks like all the other data you get when you look at this stuff. This follows an ETF that tracks the Dow Jones Industrial Average (DIA) and applies the 200-day moving average from 2002 to 2018 and compares it to just buying and holding DIA. As you can see, buying and holding had a higher return, a cumulative 302% vs 271%. However, it also suffered a much larger maximum drawdown- 52% vs 18%. You can also see some other interesting stuff, like six of the eleven trades boosted returns and five did not.

You can do it with other asset classes too, such as foreign developed market stocks using an ETF like EFA. The data looks similar:

Lower returns, but lower risk as well. There are other sites that can give you free back-tested data as well, such as etfscreen.com (although only up to 10 years). If you plug in the Vanguard Total Stock Market Index ETF (VTI) you get this:

Same story — lower returns, but significantly lower risk as manifested by maximum drawdown, standard deviation, Sharpe ratio, and other measurements of risk.

 

How Does it Compare to Bonds?

So how does this compare to another well-known method of reducing risk at the cost of reduced returns, adding bonds to the portfolio? Vanguard has a nice article about asset allocation and historical returns and risk. Here’s the meat of it:

So if you’re willing to give up 1.5% of your annualized return by using a 200-day moving average, you could simply use a 60/40 portfolio and get a similar return. So which one is less risky? Well, by one measure of risk — the maximum drawdown, the risk was about the same (note the Vanguard chart is looking at 1931 and the etfscreen.com chart is looking at 2008-2009). So historically, you got about the same thing by market-timing using a 200-day moving average and using bonds. Thus my conclusion that market-timing works, and it doesn’t. Want more opinions than just mine? Here you go.

 

What Do Experts Think About Trend-Following?

So why does this work? Larry Swedroe explains that it is due to the momentum risk factor.

As an investment style, trend-following has existed for a long time. The data from the research provides strong out-of-sample evidence beyond the substantial evidence that already existed in the literature. It also provides consistent, long-term evidence that trends have been pervasive features of global stock, bond, commodity and currency markets.

Addressing the issue of whether investors should expect trends to continue, the AQR researchers concluded: “The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.”

The bottom line is that, given the diversification benefit and the downside (tail-risk) hedging properties, a moderate portfolio allocation to trend-following strategies merits consideration.

In the other corner is Mark Hulbert, who suggests that although trend-following used to work, perhaps it no longer does.

Over the past decade…there have been at least a half-dozen times since the bull market began in March 2009 in which the index dropped below the [200 day moving average] — without triggering a bear market. On many of those occasions, in fact, the stock market rebounded almost immediately after the S&P 500 fell to below its moving average. Far from marking the beginning of a bear market, in other words, breaking below the 200-day moving average often signaled a reason to buy, not sell….Still, the 200-day moving average has had some successes. It protected followers in the financial crisis, getting them out in December 2007 and back in June 2009. The market had started rebounding in March. But its missteps during the subsequent bull market frittered away its bear-market gains.

Nor is this recent experience a fluke. Over the past three decades…an investor would have lagged a buy-and-hold strategy if he got into stocks whenever the S&P 500 was trading above its 200-day moving average and moved his portfolio to a money market fund whenever the S&P 500 was below its average.

To be sure, the 200-day moving average’s track record was better than this over the six decades through the 1980s. But its track record over those earlier decades comes with a huge footnote: It is calculated assuming no transaction costs. And that’s unrealistic. Prior to the advent of no-load index funds, and particularly exchange traded funds (ETFs), it was quite cumbersome and expensive for an investor to move out of stocks into cash, or vice versa.

It seems ironic that the 200-day moving average stopped working in the early 1990s at the very point when ETFs and discount-brokerage commissions became widely available. But Blake LeBaron…suspects there is a connection between the two. After all, it’s a hallmark of market efficiency that previously successful strategies stop working when too many investors try to follow them. In this regard, LeBaron notes that moving-average systems also stopped working in the foreign-currency market around the same time that they did for equities. It increases our confidence that the markets have undergone a fundamental shift that these strategies stopped working more or less simultaneously in two entirely different markets.

 

Final Thoughts

I don’t market time. I use bonds to reduce risk instead. If you’re not interested in using bonds because you don’t want to reduce your potential long-term returns, then you probably shouldn’t be interested in market timing either. But if you do choose to do market timing using a trend-following strategy, here are some tips to boost your risk-adjusted returns as much as possible:

1. Use good investments. Most of the time you’re buying and holding the investment anyway since the market trends upward most of the time, so you might as well use investments you would use to buy and hold. That means low-cost, broadly diversified index funds. This trend-following data isn’t some excuse to introduce uncompensated risk to your portfolio.
2. Do it in a tax-protected account. One of the reasons buy and hold works so well is that it reduces your investing costs, particularly transaction costs — the largest of which is capital gains taxes.
3. Do it in an account with free trades. Again, reduce your transaction costs. So long as the trades are free, mutual funds have even lower transaction costs than ETFs as there is no bid:ask spread.
4. Consider the value of your time. One of the best parts of buy and hold is that I can pretty much ignore my investments for months at a time. While a 200 day moving average doesn’t require very frequent trades, you do have to keep an eye on the markets.
5. Write down your plan and stick to it. The biggest problem in investing is the investor, not the investment. Once you have a reasonable plan, it is critical that you stick with it.
6. Do it only with liquid, transparent, inexpensively transacted asset classes. Don’t try to do this with your income properties.
7. Remember that this is all based on back-tested data and will only work insofar as the future resembles the past. Don’t bet the farm.

What do you think? Do you engage in market-timing using a trend-following strategy? Why or why not? Comment below!