The S&P 500 soared in January. It marked the 15th consecutive monthly advance for the index. But much like Icarus, the market went into a tailspin in early February. After the downdraft, investors are wondering if it's time to load up on bargains or if it's time to get out while the getting is good.
Even after pulling back, the S&P 500's valuation remains sky high. Professor Robert Shiller's cyclically-adjusted price-to-earnings ratio (CAPE) hit a lofty 34 by the end of January. It exceeded its 1929 peak of 32 and all other market tops except for the internet bubble when the ratio climbed to 44. By Valentine's Day, the ratio had slipped to a still expensive 32.
While the ratio does a reasonably good job of predicting long-term returns, it isn't particularly effective when it comes to timing the market in the short term. That's why I explored a simple trend-following approach in my last article, which was able to moderate the impact of crashes in the past.
As with many timing strategies, the method (based on monthly moving averages) offers similar returns to the market while reducing various measures of risk such as volatility and maximum peak-to-trough declines. It's promising but it can be improved, according to the Philosophical Economics blog.
One of the problems with trend-following techniques is that they raise the alarm bell too often. They might save your bacon when the market crashes, but they can also panic and sell after minor hiccups that occur more frequently.
The affliction can be curbed by adding fundamental economic indicators to the mix. The idea is to be wary during likely recessionary periods and to stay invested in stocks otherwise.
Real retail sales growth is one indicator that combines well with trend-following techniques. When retail sales growth turns negative, it's time for investors to be wary because it's a sign that consumers are tapped out and a recession might be near at hand.
You can track retail sales using the Federal Reserve Bank of St. Louis' free FRED service. There you can graph the measure and see how it matches up with recessionary periods. While retail sales growth turned negative during past recessions, it's a less than ideal market-timing mechanism on its own. For instance, an investor who bought the S&P 500 when retail sales growth was positive and moved into three-month Treasury bills when it was negative would have gained an average of 8.1 per cent annually from February, 1928 to November, 2015. However, the S&P 500 climbed 9.7 per cent annually over the same period. The timing strategy was out of stocks about 25 per cent of the time and missed out on some big recoveries by staying in T-bills too long.
Combining retail sales growth with the trend-following method provided better returns. The recipe is relatively simple. If retail sales have climbed over the past year then stay in stocks. If they fell, then look at the market's trend. If the market is higher than its 10-month moving average (based on monthly total return data) then stay invested in stocks; otherwise move into a safe asset like T-bills.
Basically, the only time you hide out in T-bills is when retail sales are down and the market is below its 10-month average (based on monthly data).
The dual approach provides benefits, according to Philosophical Economics. It generated average annual returns of 12.7 per cent, from January, 1947, to November, 2015, with a volatility of 12.9 per cent. (That includes a 0.3-percentage-point trading cost.) By way of comparison, the S&P 500 gained 11.2 per cent on average annually over the same period with a volatility of 14.5 per cent.
The maximum peak-to-trough downturn for the timing method was 35 per cent, which is better than the index's 51-per-cent decline. (Notice that the approach limited the downdrafts rather than eliminating them.) The timing method stayed in stocks 91 per cent of the time.
The dual approach is intriguing. It also provides a positive prognosis for the U.S. market because retail sales are up over the past year and the market is well above its monthly moving average.
Time will tell if the turmoil of the past few days is a harbinger of worse to come. But a disciplined timing approach might help to moderate portfolio downturns over the course of several market cycles.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.