How Impossible Is Market Timing?

'Market timing is impossible.'

That was the response of a certain Nobel Laureate when I tried to get him to read my paper "A Quant Approach to Tactical Asset Allocation." He refused to even take a look at it.

This year has certainly been the perfect storm for buy and hold investors. Everything has gone down - Stocks, Foreign Stocks, REITs, Commodities, and (some) bonds. This has been an instructive year to showcase the benefits of a market timing solution, namely, risk management and avoiding large losses. I have no idea how big this decline will be or when it will end, but it is instructive to take a look at some historical relative performance of the timing model vs. buy and hold investing.

October 1974 ended a period where buy and hold had its highest drawdown ever at around -20%. That has now been eclipsed by the current -30%+ drawdown. (The max timing drawdown is around -10%.)

Below is a chart for the relative returns of buy and hold vs. the timing model. Readers know that both have similar compounded returns over the past 36 years, but that the timing model has much lower volatility and drawdowns. Usually one outperforms the other by a maximum of around 10% before mean reverting. (Click on the chart to enlarge)
 

However, in times of severe market stress (now), the timing model can outperform by far greater amounts. As of the end of October it was outperforming by about 27%. Has there ever been a period comparable?

By October of 1974 the timing model was outperforming as most asset classes were declining severely (with the exception of commodities). The timing model ended the year with a gain of around 13% vs. a loss of -12% for buy and hold. However, buy and hold mean reverted over the next year, and returned about 20% for 1975 while the timing model would have done about 2%.

The million dollar question is, how bad is it gonna get? (Stay tuned for a follow-up post on some thoughts I have here.)

Comments

[fatpitch2:]

Mebane:

Thank you for your postings.

I read your longer article regarding using the very simple (approximately) 200 day moving average indicator and was quite impressed with the result.

Given that these are VERY unusual market conditions I wonder how this technique might perform "going forward". I assume the 200 day average at this point has you OUT of pretty much EVERY asset class. So a student of this model is more or less prepared for Great_Depression_2 alas.... the big question ... if you are not "invested" in any asset class and are sitting on the sidelines then you are (presumably?) actually "invested" in the paper currencies of one or more governments ....

Now I recall the pictures of post-war Germany where it took a wheelbarrow full of money to purchase a loaf of bread and that folks resorted to burning currency in their home furnaces as it was the least expensive fuel and wonder how/where one should SAFELY sit "on the sidelines" ....

Thanks!

2008 Nov 22 09:26 AM

[ACEMAN:]

Y'all are missing the point regarding the 200 day MA. Here's why: it is always much easier to look backward than to look into the near and distant future to lay your bet. And while we are at it, who, exactly is the "Nobel Laureate" mentioned in Mr Faber's opening salvo? This is classic straw-man rhetoric, to be sure. And since when is a "Quant approach" using a moving average a quantitative approach at all? I really must question the inference making syllogism in his thinking. Maybe the 19th century Danish philosopher had it right when he wrote: "We understand life backwards but live it forwards." His meaning is that we can rationalize the past, but the future is always an adventure which could be cruel.And let's not forget JM Keynes' famous saying: " The market can stay irrational longer than you can stay solvent."! The truth is that no matter how you rationalize the use of 200 day MA there is very little in it of predictability or honest inference making. It may make you "feel" good to think you have a "system" but that strategy, no matter how beautiful, does not get you results.

2008 Nov 22 01:20 PM

[dshort:]

Mebane, thanks for the instructive chart. Let me underscore the message: "This has been an instructive year to showcase the benefits of a market timing solution, namely, RISK MANAGEMENT AND AVOIDING LARGE LOSSES" [emphasis added].

Over the long haul (decades), buy/hold versus a monthly MA strategy is pretty much a wash. But If you compare betas, there's a big difference in favor of timing. I wish you had included exhibit 14 from your Quant "article" and I urge everyone to seek it out. This chart beautifully illustrates the portfolio risk management of following a monthly MA timing signal.

Of course no single strategy works best all the time. If one did, then everyone would jump aboard and then it wouldn't work at all. Theoretically, during secular periods of strongly trending price and major turning points (e.g., 1995-2008, 1927-1932, etc.), monthly timing will probably be superior to buy/hold:

dshort.com/charts/SP50...

During periods of range-bound sideways movement, it probably won't.

Over the last decade, aging boomers heavily weighted toward a buy/hold strategy have been financially devastated. For many the vision of retirement has been sadly altered.

Here's a little mental exercise for alpha seekers: Ted saved and invested for 30 years and was within 5 years of reaching his retirement nest egg target. Unfortunately, the year is 1928. A few decades later his grandson Ned saved and invested for 30 years and was about five years from his perfect nest egg. The year is 1982.

Who would have been better served by timing? Ted or Ned? Who would have been better served by buy/hold? Ted or Ned?

Now reverse the question: Who would have suffered more in each scenario? Would the chance of superior returns outweigh the risk of financial destruction?

The value of the monthly 10MA approach is not to get rich the quickest but to get rich with sharply reduced risk of financial tragedy.

Cheers,
Doug

2008 Nov 22 05:15 PM

[investor88:]

good article.

2008 Nov 23 08:20 AM

[Fabien Hug:]

What if you ask yourself the question why to buy and why to hold?
Do you buy for capital gain or for dividend? As long as you get what you want you hold, otherwise you sell. I bought WM at 15 in 1998 and hold all the way because it was paying dividends. I could have sold at 45 in 2007 and then what. Where do you put the money? A CD? I already had a full CD allocation. I finally sold WM at 15 in 2008 when they cut the dividend.
I don't cry over the money I haven't made because it could have gone the opposite direction as well when you read about the economy in early and mid 2008.

2008 Nov 23 10:00 AM

[kojenku:]

Mebane's model generates whipsaws. How do I reduce whipsaws? The model is working in the current market, and I have to give him two thumbs up and two toes up, as this is the only free article I know that backtest in detail, and easy to implement in just plain Excel worksheet.

2008 Nov 23 01:13 PM

[Jason Wenk:]

To reduce "whipsaws" add a few asset classes to your excel model and add additional buy/sell rules. As an example, use 10 asset classes each with a timing method (200MA; 40/200MA crossover; etc.) and also rank the performance of each asset class over various periods. This can be done by adding a column to your spreadsheet of historical data that computates the sum of 3, 6, and 12 month returns, for example. You could use a simple RSI calculation as well. Only buy the top 5 (or 4, 6, 8 - you'll see what happens as you test) asset classes. When this is done you can actually see increased returns and reduced volatility to the simple model created by Mebane.

Also, for those who question the validity of Mebane's research and don't refer to it as true "quant" - I too think you're missing the point. I believe his primary purpose in this article is to urge readers that buy and hold may work over very long time periods, but will cause significant drawdown in bear markets. I would think he publishes this for free to make a point but has additional tools for his practice that are more refined.

2008 Dec 05 02:22 PM

[User 329378:]

You are right on. This guy mebane is a total hack. I checked out his firm's website and found not one but two direct plagiarisms from Goldman Sachs mission statement: number 1 "we founded our firm on the basis of four premises. First, our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." number 2 "our assets are our people, capital and reputation. If any of these is ever diminished, the last is the most difficult to restore". Ironically, the rest of the website goes on to talk about the ethics and their moral compass. Seriously, why would anyone ever listen to this joker. This guy reminds me of the quote from the movie wallstreet by Hal Hal Holbrook "Kid, you're on a roll. Enjoy it while it lasts, 'cause it never does." Actually, I must ask why anyone listens to this joker. Am I really the only guy that has gone to the website and noticed all the plagiarism? Apparently, his strategy is better than harvard or yale's. If that is the case he should market it to them I am sure his advanced mathematics will blow them away and they will hire him to manage all those billions of dollars....then again, maybe not.


On Nov 22 01:20 PM ACEMAN wrote:

> Y'all are missing the point regarding the 200 day MA. Here's why:
> it is always much easier to look backward than to look into the near
> and distant future to lay your bet. And while we are at it, who,
> exactly is the "Nobel Laureate" mentioned in Mr Faber's opening salvo?
> This is classic straw-man rhetoric, to be sure. And since when is
> a "Quant approach" using a moving average a quantitative approach
> at all? I really must question the inference making syllogism in
> his thinking. Maybe the 19th century Danish philosopher had it right
> when he wrote: "We understand life backwards but live it forwards."
> His meaning is that we can rationalize the past, but the future is
> always an adventure which could be cruel.And let's not forget JM
> Keynes' famous saying: " The market can stay irrational longer than
> you can stay solvent."! The truth is that no matter how you rationalize
> the use of 200 day MA there is very little in it of predictability
> or honest inference making. It may make you "feel" good to think
> you have a "system" but that strategy, no matter how beautiful, does
> not get you results.

Jan 01 01:19 PM

[kojenku:]

NO ONE CAN PREDICT THE FUTURE.

PERIOD.

ONE CAN ONLY GUESS AND BET, AND THIS IS WHAT MEBANE'S MODEL IS FOR. EASY TO FOLLOW AND IMPLEMENT FOR AVERAGE INVESTORS.

WHEN YOU GUESS AND BET, YOU RUN THE RISK OF BETTING THE WRONG SIDE, OR RIGHT SIDE OF THE MARKET.

If you are looking for the investment opportunity that gives positive returns all the time without losing years, look to Bernie Maddoff and his Ponzi company. His company is much better than hedge funds.





On Jan 01 01:19 PM User 329378 wrote:

> You are right on. This guy mebane is a total hack. I checked out
> his firm's website and found not one but two direct plagiarisms from
> Goldman Sachs mission statement: number 1 "we founded our firm on
> the basis of four premises. First, our clients' interests always
> come first. Our experience shows that if we serve our clients well,
> our own success will follow." number 2 "our assets are our people,
> capital and reputation. If any of these is ever diminished, the last
> is the most difficult to restore". Ironically, the rest of the website
> goes on to talk about the ethics and their moral compass. Seriously,
> why would anyone ever listen to this joker. This guy reminds me
> of the quote from the movie wallstreet by Hal Hal Holbrook "Kid,
> you're on a roll. Enjoy it while it lasts, 'cause it never does."
> Actually, I must ask why anyone listens to this joker. Am I really
> the only guy that has gone to the website and noticed all the plagiarism?
> Apparently, his strategy is better than harvard or yale's. If that
> is the case he should market it to them I am sure his advanced mathematics
> will blow them away and they will hire him to manage all those billions
> of dollars....then again, maybe not.

Jan 14 07:55 PM