How To Time The Market Without The Emotional Baggage

How To Time The Market Without The Emotional Baggage

Investors aren’t supposed to try to time the market. There’s little guarantee that a macroeconomic insight isn’t already priced in. Worse, asset allocation decisions based on recent events are subject to the emotional and cognitive biases hardwired into the human brain. Don’t time the market – you’ll hurt yourself. In the long run, patience and an appropriate risk budget make winners out of most investors.

I almost totally agree. I find the behavioral arguments against discretionary market timing very compelling (if difficult to follow myself). But I’m not 100% against market timing. Here’s why.

  1. Emotionally, it’s easy for investors to talk a big game about the risk they can handle when markets are trending higher. But few people know themselves well enough to be sure they will react calmly when portfolio values are plummeting.
  2. The long-run expected return for stocks is positive, but investors are not expected-return-optimizing bots. We have cash flow needs and finite time horizons. Related:
  3. Many investors may need to tap into their investment portfolios if they face a long enough period of unemployment, or a medical emergency. Amid the COVID-19 pandemic, both of these are realistic, and bad news can tend to pile up as the economy deteriorates. Selling as your wealth level plummets is more distressing, and potentially more harmful to long-run performance, than selling out of more a stable asset base.
  4. Stocks do experience decade-long bouts of weak or negative performance.

So I believe investors should consider strategies that may help sidestep stocks’ occasional sharp drawdowns.

For investors who have a high-conviction negative view of the market, such strategies offer a way to take action on their bearish beliefs without necessarily subjecting their portfolios to the dangers of their cognitive and emotional bias.

I should note that right now I am bearish on stocks’ long run expected returns and recently reduced stock market exposure in my own portfolio. I guess a no-market-timing policy doesn’t work for me.

Systematic Market Timing

Any investor who’s interested in shifting asset allocations to time the direction of the stock market must read Meb Faber’s 2006 working paper, A Quantitative Approach to Tactical Asset Allocations. Faber finds a simple 10-month moving average strategy greatly improves portfolio volatility and drawdowns without dramatically sacrificing long-run returns. If Faber’s analysis is correct, the bears among us can potentially have our cake and eat it too – taking action when conditions may be deteriorating, but largely preserving our exposure to stocks’ strong long-run expected performance.

There are many different approaches to market timing – many technical analysts use a variety of indicators to follow trends.

There are many versions of trend following. I believe most of the successful market-timing tactical asset allocation models tend to approach the same general phenomenon from different angles, be they 12-month momentum, an exponential moving average strategy, etc. Corey Hoffstein at Newfound Research has done a lot of work on different model specifications, and I recommend this post as a starting point.

I have chosen to highlight Faber’s method for a few reasons:

  • I believe it adequately captures the long-run tendency of the market to trend upward or downward.
  • It has relatively low turnover.
  • It is simple to implement. Reduced ambiguity of the indicator should make it easier for investors to adhere to the strategy.

Here is Faber’s description of the strategy:

BUY RULE

Buy when monthly price > 10-month SMA [simple moving average of prices at the end of the previous 10 months].

SELL RULE

Sell and move to cash when monthly price < 10-month SMA.

1. All entry and exit prices are on the day of the signal at the close. The model is only updated once a month on the last day of the month. Price fluctuations during the rest of the month are ignored.

2. All data series are total return series including dividends, updated monthly.

3. Cash returns are estimated with 90-day Treasury bills, and margin rates (for leveraged models to be discussed later) are estimated with the broker call rate.

4. Taxes, commissions, and slippage are excluded (see the Practical Considerations section later in the paper).

The version of Faber’s study linked above concludes in 2012. I have attempted to re-create his modeled systematic portfolio using the above parameters. Here is the long-run track record for the market timing strategy compared to a passive strategy applied to the S&P 500 from 1901 through May 2020.

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(Source: Robert Shiller data library, strategy derived from Meb Faber. Note that although I attempted to exactly replicate Faber’s methods, the summary statistics are slightly off from the 1901 – 2012 time frame. Possible sources of discrepancy are my estimate of the T-bill rate from 1901-1927, difference in the exact start date for our portfolios, or something else. Our results are pretty close, though.)

This chart is potentially deceiving. It can look to an untrained eye like the tactical/market timing strategy has uniformly beaten a passive allocation to the S&P 500, but this is not true. If you look closely, there are many periods – long ones – where the S&P “catches up” to the tactical strategy. Those are periods when passive investment in the S&P 500 offers better absolute returns than a tactical strategy.

Here is Faber’s summary of a tactical market timing model’s impact on a U.S. stock portfolio. Although there is an advantage in absolute return for the timing model, the more striking divergences are in volatility and drawdown; Tactical may or may not be much better than passive on a return basis, but it does a great job of addressing downside risk.

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Faber alludes to the seemingly inconclusive long-term return benefits of a tactical strategy, noting that if you’re only looking for returns, tactical and passive stock investment are about the same:

While the timing model outperforms in about half of all decades on an absolute basis, it improves risk-adjusted returns in about two-thirds of all decades and improves drawdown in all but two decades.

Faber’s research offers investors a simple strategy that’s relatively easy to implement. Its systematic nature removes human cognitive and emotional biases from the decision process. And it significantly improves risk-adjusted portfolio performance. Most important, the strategy has historically mitigated the most painful market drawdowns on record, preserving investor capital amid some very challenging economic times in the real world.

Economic Rationale

Any investment strategy should address the real-world drivers of its success. I believe the disposition effect means bad news makes it into the market over protracted periods, as investors remain in denial and hope that by holding on they can recover the losses incurred so far:

Unlike those in models, real investors tend to sell winning investments while holding on to their losing investments—a behavior dubbed the “disposition effect”. The disposition effect is among the most widely replicated observations regarding the behavior of individual investors. (Source)

This refusal to sell when times get rough helps prolong market downtrends. If you think of a stock’s price as the weighted average of buyer and seller behavior, then people’s aversion to loss realization should prolong downtrends; bad news comes, and investors refuse to sell based on the new information, and this refusal supports the price, creating a downward drift rather than an instant reaction. Selling winners has the opposite effect on the way up. Meanwhile, piling into or out of stocks during moments of sheer euphoria or panic can also reinforce trends in market prices. These are strong psychological forces, and I believe they serve as long-run drivers of trends in the stock market.

I also believe trend following can continue to deliver strong risk-adjusted performance and has not been/will not be arbitraged away. My reasons:

  • It’s emotionally harder than it looks. In choppy markets or strongly trending bull markets, systematic trend following lags passive investing, which can prompt investors to abandon the systematic discipline and ignore risk-off signals.
  • It’s not intellectually gratifying. The system is too dull and simplistic to be of interest to most investors looking for an edge in the markets. Following a moving average strategy is not something to brag about at parties.
  • Its absolute return profile is unexciting. Based on historical performance, investors shouldn’t expect to beat the market using this timing strategy – only to smooth their returns and hopefully preserve their capital in times of economic stress.

Risks

This strategy’s primary objective is to reduce drawdown risk; shifting from volatile stocks into lower-returning but less volatile assets like cash or short-term T-bills is rarely going to exacerbate portfolio downside risk. Instead, the risk to this strategy manifests as the chance of missing out on returns accruing to the upside. False trend following signals in choppy sideways markets can drive underperformance of an index, invite excess portfolio churn, and hamper performance. As Faber notes, on decade-long time frames this strategy underperforms passive indexing about half the time. While that is a notable attribute to this strategy, it’s a sacrifice many investors may be willing to make, given the potential to reduce portfolio drawdowns during economically stressful periods.

Conclusion

Timing the market is not complete folly; only discretionary, emotional market timing is. A systematic strategy with a long-run track record of improving portfolio drawdowns, reducing volatility, and preserving long-run expected returns to stock investment is worth a great deal of consideration.

For investors who do have a bearish view of the market but may be rightly suspicious of their individual ability to successfully sell out of stocks at the right time, a partial allocation to a systematic market timing strategy might be an appropriate risk management tool.

For reference, the S&P 500 is currently about 6% above its 10 month moving price average.

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(Source: Yahoo! Finance)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long VAR, MDP, ERUS, EPOL, TUR, and a variety of low-cost, broadly diversified index funds.

Source: Seeking Alpha

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