Some people prefer to stay 100% invested at all times. Doing so removes the emotional anguish of wondering when to invest and when to raise cash. Such an investor will buy the highs and the lows for average market performance.
Other people attempt to time the market. They may use market-wide valuation, a trailing moving average, sentiment or some other mechanism to give broad signals of when they should be invested in the market or not. They are either 'all in' or 'all out'.
But how many investors do you know that go 100% in or out of the market? Probably not many at all. The S&P 500 (NYSEARCA:SPY) market timing approach I will discuss is not some signal that tells you to 100% buy or 100% sell. The system below will tell you the % invested you should be at any given time. In some markets you should be 100% invested and at other times 0% invested while the far majority of the time you will be in the 30 - 80% range.
To be clear, this isn't a system where you buy and sell the 500 stocks in the index. Before I discuss how this model is built - you need to understand how it works and how to trade it.
How To Read The S&P 500 Market-Timing System
The system will try to invest in all 500 stock of the S&P 500. Based on the market-influenced rules mentioned below, it will reduce holdings. At times this portfolio will only hold 100 stocks or 200 stock or sometimes all 500. Simply look to the % invested in this equal-weighted market-timed index that I will create. This is the recommended amount you should invest regardless of the stock, industry or sector you choose - if you wish to reduce broad market risk.
The system holds 200 out of 500 stocks. The portfolio is 40% invested. To follow this system you should have 40% of your investment capital invested in the market and be sitting on 60% cash.
Or, this system is holding 400 stocks out of a potential 500. Thus, you should be 80% long invested regardless of where in the market you are buying.
The S&P 500 is used only as a gauge - although no specific stock recommendation is made using this system.
My S&P 500 Market-Timing System
There are three parts to my market-timing system:
- Fundamental trend
- Price trend
- Price correlation
Lack of Valuation
Before I begin, I need to acknowledge what is lacking... a rule for valuation. At no point do I analyze the S&P 500 earnings yield. Why?
While I use relative valuation in order to decide which stocks are at the best prices, I rarely use valuation as an absolute filter. For instance, I would not set a hard rule saying that my dividend stock needed to be above 5%...what's wrong with 4.95%? But I will pick the highest yielding deciles in an index where the fluctuating yield is around 5%. So too with the market, I find it challenging to pick an absolute valuation (e.g. PE ratio of 18) that triggers a broad buy or sell rule.
So no valuation is added into this market-timing system.
S&P 500 Fundamental Trend
This is a buy-side rule only. It will only tell you when you can buy but it will not signal a sell. If the rule is positive - you can purchase securities. If the signal is negative - you cease buying but you do not sell (based on this rule).
The first filter looks at the S&P 500 aggregate earnings expectation. In general, you want earnings to go up in order to sustain a bull market. Earnings that are trending down often indicate a troubled economy and prices usually fall in a simultaneous trend.
My first rule needs the S&P 500 current year earnings estimate to be trending upwards. The 3 week moving average (S&P 500 EPS CY) must be above the 15 week. (see chart below for S&P 500 EPS trend produced by Portfolio123 although the moving averages are not shown)
But this rule doesn't always work. Yes, if the earnings are trending up and the index is trending down it may be a good time to buy...but what happens when the earnings are trending down and the government starts printing money (quantitative easing) and propping up the market? That is a problem... which is why I created a second rule related to index price performance.
S&P 500 Price Performance
This rule has an OR logic. Either the S&P 500 EPS needs to be in an uptrend (see above) OR the S&P 500 price needs to be in an uptrend. I use the 75 day weighted moving average as my signal.
Again, this is a buy-side rule only. If the index falls below the 75 day moving average I do not necessarily sell. But I can only invest more when either the market is in a technical or a fundamental up trend.
Now for those of you wondering how well these two rules work together if you used them as buy and sell rules... here is a chart showing backtested performance since 1999 in the S&P 500.
Yet, how many people do you know that have the constitution to go all in or all out? Not many. So while using these two rules works well to go 100% in or out - I only use it on the buy-side. I do not sell based on these signals - although you could modify this system to add a hedge when the price and fundamental trends are both down. We will try that at the end of the article.
S&P 500 Price Correlation
The third rule is independent of the other two and runs on the buy and sell side. The theory is this...prices are more highly correlated to one another in a bear market when fear is dumping stock at the same time. Thus, if we use maximum price correlation rules in the S&P 500 - we should start selling off holdings in bad markets and accumulate shares in good markets. This will be a progressive buying and selling system.
Here is why this rule might work. Investors want diversification so that some prices move up and some move down for a smoother portfolio ride. But when prices are moving together - you are at a higher volatility risk. Your portfolio moves up and down like water sloshing in a bathtub. You need to reduce your highest correlated holdings (to the S&P 500 index price movement) and get back some price independence. In a bear market when everything is moving the same direction, your correlation rules will reduce your positions until you are sitting on a lot of cash. You get back in the market during a lower correlation environment - when markets are moving up.
Putting It All Together
This is how the system works...
It looks for either an upwards price trend or a earnings estimate up trend before buying is allowed. If buying is allowed, it must meet some correlation requirements that are not very strict.
If market prices swing to a downtrend and the earnings are in a downtrend - buying new stock is prevented. But your capital is still largely invested. Your positions will be reduced based on price correlation as each holding is compared to your 'S&P 500 portfolio'. Your exposure declines until either the S&P 500 earnings or the price starts to trend up - and then holdings must meet the max correlation requirement to be purchased.
This chart shows price performance, on-going drawdown and % invested since 1999 in the S&P 500. You can follow a chart that updates here for those that like the idea and want to follow it freely.
The market-timing system is currently 54% invested in the market.
Adding A Hedge
What about adding a hedge? The chart below adds a 100% hedge on the equity when both the price and earnings of the S&P 500 are trending downwards. This reduces max drawdown to 12% with a 7.14% annual return and a 0.28 Sharpe Ratio. This is not too bad considering we haven't even looked at stock picking and are simply basing this on broad market-timing.
There are no sure bets in the market. But by combining correlation, price and earnings trend in a broad S&P 500 portfolio - you can keep cash in your savings account when risk of a drop is high.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.