Audiences were thrilled with the opening scenes of the original Star Wars movie in 1977. The tale starts as Darth Vader boards Princess Leia's rebel ship in a flurry of death and destruction while the buddy-droid duo C-3PO and R2-D2 make their getaway in an escape pod.
I've been eyeing escape pods – as an investor – for some time now. The U.S. market blasted through valuation levels seen at the 1929 market top in recent weeks. I outlined the dire situation using Prof. Robert Shiller's CAPE ratio (cyclically adjusted price-to-earnings ratio) in early January and matters have deteriorated since then.
Problem is, while the CAPE ratio does a reasonably good job when it comes to predicting long-term returns, it is less effective when used as market-timing tool. As a timer, it is about as accurate as a stormtrooper's errant blaster fire.
But investors can find new hope by turning to the world of trend-following and momentum. Today, I'm going to focus in on a few of the results from the Philosophical Economics blog's market-timing opus. Its author goes by the pseudonym Jesse Livermore on Twitter in honour of the famous speculator who made, and lost, fortunes in the early 20th century.
The timing measure studied is a simple one. Each month, the current level of a stock-market index (including dividend reinvestment) is compared with the average of its 10 prior monthly readings. If the current reading is higher than the average, it's time to buy stocks. Otherwise, it's time to go to cash or some other safe asset. (The following calculations include trading costs of 0.3 per cent.)
In one test, the S&P 500 was used as the index and three-month U.S. Treasury bills (T-bills) provided the safe haven. The S&P 500 posted annual gains of 9.7 per cent from February, 1928, to November, 2015, while T-bills climbed at a rate of 3.5 per cent.
Coincidentally, the timing strategy also gained 9.7 per cent annually over that period, but it was invested in the S&P 500 only 72 per cent of the time and it was in T-bills for the rest of the time. By way of comparison, a regularly rebalanced portfolio with 72 per cent in the S&P 500 and 28 per cent in T-bills gained an average of 8.4 per cent over the same period.
The timing approach excelled when it came to measures of risk. For instance, its maximum drawdown, or peak-to-trough decline during the period, was about 50 per cent versus 83 per cent for the S&P 500. It also had a relatively low volatility of 12.7 per cent whereas the S&P 500 clocked in at 19.1 per cent.
The results were similar north of the border. In Canadian dollar terms, the Canadian stock market gained an average of 9.8 per cent annually from the start of 1971 to July, 2015, while Government of Canada T-bills climbed 6.1 per cent annually. The timing strategy advanced 9.8 per cent annually while spending 75 per cent of the time in stocks. A benchmark portfolio with 75 per cent in Canadian stocks and 25 per cent in T-bills gained an average of 9.2 per cent annually over the period.
Once again, the timing strategy reduced risk with a maximum drawdown of 28.3 per cent versus 47.1 per cent for the Canadian market. The market's volatility clocked in at 16.4 per cent whereas the timing method's volatility was a more reasonable 12.9 per cent.
A few words of caution are in order. The potential impact of taxation is not included in these figures. While taxes might not be a concern for those with RRSPs or TFSAs, those with taxable accounts aren't so lucky.
In addition, the timing strategy is, much like a startled C-3PO – a bit twitchy. The approach switches between stocks and T-bills in about 10 per cent of the months over the span of the study. That's not too bad if the trades are winning ones. But the switches are counterproductive 75 per cent of the time. On the other hand, they more than make up for it by avoiding big market crashes. As a result, the strategy comes with many small disappointments and a few big wins.
Happily, the U.S. and Canadian markets have been climbing and aren't due for an immediate meltdown based on this simple strategy. So, investors can hit light speed and cruise to the market on Alderaan. They just have to keep an eye out for the Death Star, which will eventually crash the party.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.