Financial theory claims it doesn’t work, but in recent years more and more studies have appeared suggesting that it might work after all.*
In addition to the efficient market hypothesis, a commonly used argument against market timing is: “if you happen to miss just the 10 best days in the market it will drastically reduce your returns”. Pundits usually fail to analyze the distribution of the best and worst days – an overwhelming majority of both the best and the worst days are clustered in a high volatility environment – usually when the market is already down considerably. And missing both the best and worst days will actually boost your risk-adjusted return, if it can be achieved.
The financial news is constantly bombarding investors with stories and indications trying to predict the future of asset prices – everybody is influenced by these constant and often contradictory calls to action.
Simplifying this deluge is essential and maybe a good question to ask ourselves is:
How can market timing be useful to my portfolio and my consistency in managing it?
This is my main focus: loss avoidance to beat the market in bad years and to reduce the drawdowns of individual strategies. Reduction in volatility is very valuable, even if the overall return stays the same – returns can then be adjusted through leverage.
Lower volatility will also make it easier to stay the course during bad times – which is incredibly hard to do when facing drawdowns of -40%, -50% or more. Be aware, that your risk tolerance will change with the size of drawdowns. At new equity highs risk appetite seems unlimited, with growing drawdowns risk tolerance shrinks rapidly, causing investors to throw in the towel.
The basic premise for me is that predictions generally are not reliable enough to be useful in practice. The future is unknowable and investing is a probabilistic game largely determined by randomness – we rely on historical data to figure out where probabilities might be in our favor and a certain “stickiness” of market environments.
To me the most promising way to attempt to time the market successfully is by adjusting our portfolio allocation to the current state of the market.
Fundamental data allows us to be prepared for what might happen, while technical indicators provide the timing, by showing that the market has in fact changed its regime.
To me the six key states markets can be in are:
going up, sideways or going down while either being calm or being volatile.
- Cape ratio for valuation: high or low compared to historic averages
- Yield as another valuation measurement, especially useful for bonds
- rising or falling GDP and earnings growth – most useful are leading economic indicators as, for example, trends in unemployment rates or the treasury yield curve
- Lending activity: easy or tight credit
- Investor sentiment: excessive optimism or pessimism in extrapolating recent returns into the future works as a contra indicator, trusting that regression to the mean will happen eventually
- Increasing asset class or strategy popularity leads to momentum then to overcrowding
- Overcrowding (or ignorance) of ideas and market areas: no one is left to buy (or sell) and prices are likely to revert
- Inflation and interest rates
Equities generally move in the same direction as economic growth over the long term – major bear markets happen in the context of economic recessions. This can be helpful in separating harmless corrections from growing probabilities of a major bear market, depending on the trends of leading economic indicators.
But mainly fundamental tools create an awareness of what is going on, which leads to being prepared to act when change actually starts to happen. The market can get even more expensive or cheap for an extended period of time, which will cause unnecessary losses or missed opportunities, if one acts to early. It´s better to be a little late to the party (or the exit) and to wait for confirmation through very simple technical indicators before changing strategies more radically.
- The simplest and most effective measurement of the up- or down-trending state of a market is whether price trades above or below its long-term moving average. I prefer to shift away from the commonly used 200-day moving average a little bit to avoid the crowd – whipsaws are likely to increase around widely followed measurements. For evaluating my allocation to equities overall I use the state of the world market ETF VT.
- Rules for asset classes, countries, sectors and factor ETF are very simple: Reduce to a basic allocation (which may be 0 or some fraction that you are prepared to hold through a prolonged downturn) when the ETF trades below the moving average. Go back to your defined allocation when the ETF trades above the moving average. When you are out of several market areas you have to think about whether to stay in cash or to shift allocations to strategies that are still performing well.
- The moving average acts as a trailing stop loss, but for some volatile strategies it makes sense to define a maximum loss through a defined stop loss. Large gaps or sudden crashes, similar to the October 1987 crash, can possibly lead to much larger losses than your stops suggest.
- When assets have been down more than three years in a row, regression to the mean is likely to kick in in the near future.
- To measure, when the market changes volatility regimes, gets more complex, but it yields some valuable information – indispensable when trading volatility: the key data comes from VIX levels and the VIX Futures Term Structure – research in this area has provided me with a lot of valuable insights.
In general an upward sloping VIX Futures Term Structure (prices of VIX futures farther from expiration are more and more expensive) means all is well for equities and short volatility strategies and an inversion of the Term Structure – when it becomes downward sloping – is a warning sign triggering my immediate exit from short volatility strategies. The market falling below its long term moving average, while the VIX Futures Term Structure inverts is a doubly strong warning sign.
The propensity of volatility to cluster, implies that market regimes tend to stick around for a while before changing again.
- Rising volatility in a rising market is another good indication that trouble may lie ahead. It can be used to reduce exposure before prices actually turn. A good example is 2007 when volatility started to rise steadily from very low levels, while the market still looked very benign. Underneath the surface a lot of quantitative strategies suffered meltdowns long before the advent of the financial crisis.
- Other technical indicators don´t hold much in store for me. Most are just further derivatives of price, diluting the available information or discretionary line drawing on charts without objective value. The concepts of support and resistance are just as well manifest in moving averages as in horizontal or trending lines drawn by hand.
A good rule of thumb is to drastically reduce exposure to a fraction of your capital and move to a higher cash position, when volatility spikes and more and more ETF break their long term uptrend. A crisis occurs when unexpected events meet risky, levered structures and we want to avoid being part of that. Going into hibernation may be more effective than trying to trade the short side with bear market strategies. Try to lose as little as possible in volatile bad times by radically reducing exposure. Downturns are usually violent and short and provide great opportunities on the long side when they pass and you have preserved enough cash to be able to use these opportunities. It pays to be patient as the market spends about 75% of the time going up. This implies that going short equities unsystematically goes against the basic probability distribution (i.e. the equity risk premium) and therefore is a losing game on average, unless done with exceptional skill within the framework of a proven strategy.
Adapting option strategies is another way to actively trade downturns in the market. A strategy of selling a portfolio of diversified index options could be implemented with a directional tilt: sell puts on index ETF above their moving average, sell calls on index ETF below their moving average, creating a weighted option strangle over different underlying securities. This tactic will tilt your short option exposure towards the direction the majority of markets has and change that weight gradually when markets break their trends at different times.
A good concept is to probe for weaknesses: use stress tests to figure out what could be wrong with your ideas and systems and to make the whole construct more robust.
Whenever major mistakes occur or your portfolio suffers a deep drawdown, thorough analysis will help to improve your process in the future.
More details can be found in the article series “Working with different Market Regimes”