January 13th, 2010

Beat the Market With Market Timing

I’ve long held the view that beating the market on a long-term basis is more a question of market timing (when to be in and when out) and cash management than superior stock picking. If you stick with the market leaders, try to limit losses from bad picks and move into cash as the market weakens, then you’ll have a good chance of outperforming the benchmark.

But this idea, whether applied to institutional, professional fund managers or individual has been long debated. Mark Hulbert added his view to the argument this past Sunday in the NY Times in his article, “Beating the Market: It’s Still a Tall Order“. Hulbert concludes that “If active management doesn’t acquit itself in a five-year period that includes the worst bear market since the Depression, then it’s yet more compelling evidence that most investors should not even try.”

As evidence for his conclusion, he offers a study from his Hulbert Financial Digest that tracked the performance of hypothetical portfolios set-up by editors of 200 investment newsletters; the editors employed a combination of market timing and sector rotation techniques to decide which funds to buy and sell, as well as when to do so.

Of those newsletters, the eleven that were essentially bear funds performed well during the recent market crash (one gained 75% will the market declined 50%) but lost money over five years preceding the crash so it gained a mere 1%, nearly equal to the Index, over the whole period. According to Hulbert,

“many of the advisers who manage them [bear funds] have been predominantly bearish for a number of years, not just during the bear market. Their model portfolios therefore lagged behind a buy-and-hold approach when the market started rising again. From the beginning of March through December, for example, the 11 model portfolios lost 5.1 percent, on average, versus a 56 percent gain for the Vanguard index fund.”

Hence the conclusion that “performance during a bear market has little to do with long-term returns. Both the best and the worst bear-market portfolios had difficulty beating a buy-and-hold approach over the longer term.”

But what if an investor pursues a long/cash strategy. Tracks the index during up markets and avoids the market during down periods. That’s essential what I attempted to do and, since January 1, 2003, have been able to beat the market by about 80% (the blue line in the chart below indicating the relative performance):

I’m not saying that market timing is but it’s not impossible either. I assert based on my experience that if you manage the amount of money you put at risk (by scaling in when the market is in a clear up trend and scaling down as it loses momentum) then, over the long run, you’ll be ahead of a strict buy and hold strategy or a portfolio fully invested in an index fund.

Market timing doesn’t mean predicting the future. What market timing means is finding the major turns in the direction of market momentum and reacting appropriately. Simple indicators for finding those major turns is the Index’s position relative to its 200- and 300-day moving averages.

Being too far ahead of its moving averages is almost as detrimental to forward movement as is crossing over these moving averages. The market today is extended (too far ahead of the moving averages), thus the discussion of a correction (see “More Evidence A Correction Is On The Way“). But a correction doesn’t mean a trend reversal and doesn’t mean you need to dump you holdings. It does mean, however, you should be prepared for a 10-15% correction by hedging or by lighten your exposure to risk (increasing your cash position).

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