In a recent headline story on Marketwatch.com, Mark Hulbert reports that merely owning two Vanguard index funds, one for the entire US stock market and the other for high grade US bonds, 80% in the former and 20% in the latter, outperformed the average market timer.
The two-fund portfolio would have gained an uninspiring average 3.7% a year from early 2000 through this past June 30, while the average market timer only 2.1%. And it would have also done better than the 2.9% return for a portfolio that was 100% invested in just the stock fund alone with no further diversification. Therefore, he concludes that such a buy and hold approach is likely a better strategy than trying to get in and out of the stock market at the "right" time, or which shuns bonds altogether.
On the other hand, stocks are now perched near all-time highs and have been in a massive bull market for over 4 straight years. Although there have been three corrections of 10% or more since its beginning in March 2009, we now have gone nearly 14 months since the last one and many people, it seems, are engaging in the perpetually never-ending effort to look into their own particular crystal ball and attempt to somehow successfully sidestep the next big drop.
In a recent article on Seeking Alpha, I expressed the opinion that the current uptrend in the stock market may, based on my own empirical research, change course some time this fall. This is mainly due to data that suggest that without a significant correction, stocks will fall into overvalued territory by then, and overvalued assets are pretty synonymous for me with assets that are likely to show disappointing forward performance.
Is it possible to know with any degree of certainty when one should avoid the overall market, either because it has reached near unsustainable levels or even perhaps because of any of a myriad of economic indicators that seem to suggest trouble? Not to my way of thinking. But investors do have the option to try to anticipate and then act early when returns are still rising but appear unlikely to continue at a satisfactory pace.
A few years back, in the newsletter I have been writing for over 14 years, I presented a relatively simple strategy for making investment decisions regarding the overall market. While it requires no market timing skills nor any other type of sophisticated analysis, if it had been followed over the prior decade, would have lead to much better results than by merely buying and holding. Since the exact details of this strategy, although not the general thrust it recommends, were only devised "after-the-fact" (that is, in analyzing what had already been the case), one might readily argue that while it would have worked during 2000-2009, we do not at all know whether it would also work projecting forward.
A Buy and Sell Strategy
Here is the strategy in a nutshell: Sell some of your stocks every time there is a 25% rise in the S&P 500 index, buy additional stocks whenever there is a 10% drop in the index. Each additional rise or drop calls for an additional sale or purchase. For example, a rise of 50% without a 10% correction requires one sale at 25% and one at 50%.
The strategy helps to ensure that one buys low and sells high. Further, when strictly practiced, it takes all the subjective and/or emotional elements out of your decisions. You don't have to "figure out" when the time is ripe to take action based on anything else.
My above-referenced research has already shown that the strategy could have prevented the losses many investors suffered who merely held on to their broad market funds during the last decade. Instead, it led to modest gains. So the question arises as to how the strategy would have performed beginning in the current decade, that is, starting in Jan. 2010, when stocks have been predominantly strong, at least thus far.
When the strategy is applied continuing from gains achieved after the 2007-2009 bear market ended, the results show a huge improvement from even the already outstanding results investors have been getting over the last 3 1/2-plus years.
The following table shows, along with the key selling and buying and mileposts, the results for anyone using the strategy assuming they entered 2010 with a $10,000 investment in the SPDR S&P 500 ETF (NYSEARCA:SPY) vs. someone who merely held the same investment continuously in the Fund without any sales or new purchases. Investors who instead choose a mutual fund such as the Vanguard S&P 500 Index Fund (MUTF:VFINX) should note that they will obtain nearly the identical results.
I used the following assumptions in showing the results:
- Decisions began based on where the S&P 500 index was off the March 9, 2009, low.
- Milestone 10% drops or 25% rises are percentage change in the index in relation to an earlier high or low point - two or more consecutive drops or rises use percentage change from the original level.
- Each buy/sell was for $3,000 and was made at the closing price on the date shown. Cash resulting from sales were held in a non-interest bearing account and, if available, was used to fund any subsequent purchases.
|Fund Sales and Purchases for the Period|
Beginning Jan. 2010 through July 2013
of SPDR S&P 500
Note 1: The S&P 500 index began 2010 at 1115 and is currently at 1692; SPY began 2010 priced at 111.44 and is currently at 169.11 (data through July 26).
Note 2: Values shown for investments do not reflect any additional dividends or capital gains that may have been distributed, nor do returns shown below.
Based on the current SPY price of 169.11:
- The value of buy/sell investor's account would be $17,381 for a cumulative return of 73.8% (20.7% annualized) over the period.
- The value of buy/hold investor's account would be $15,174, for a cumulative return of 51.7% (14.5% annualized) over the period.
- In other words, the buy/sell investor would currently have $2,207 more in his/her account than the buy/hold investor, or a 6.2% better annualized return.
Why the Strategy Proved Superior
It is important to grasp why the buy/sell investor would have done so much better. After the first sale, the market did experience a 10% correction, not surprising after it had already gone up 75% without experiencing one. Since the price went down and the investor had less shares, this investor lost less. By buying when the price dropped, the investor purchased more shares at a lower price than they were at the start of the decade and now had more shares than the buy/hold investor, and thus, was already doing better after several months of rising prices.
The process of selling high and buying low kept repeating a number of times. Thus, by the end of the period, while the buy/hold investor held the same number of shares as when the decade began (remember, we are not including dividends or capital gains), the buy/sell investor had significantly more shares than the buy/hold investor. Having more shares meant the buy/sell investor was far ahead in the value of his account.
Note that if the price of shares had continued going up without any 10% drops over the entire period, the investor who gradually sold some shares would have come out behind. But such a "straight up" rise in the market is relatively rare. Likewise, if the price of shares had just gone down steadily, an investor who bought on 10% drops would also now be behind because he would have lost more and more money after each purchase. This too would likely almost never happen over the course of a decade, the period for which this strategy is recommended.
Some Additional Considerations
Of course, one's performance results might vary depending upon what percentage one decides to sell or buy in relation to their original investment. In the above example, I chose to sell or buy 30% of the original investment at each milestone (i.e. 3K in relation to a 10K original investment). If, however, I had chosen 50% instead, the outperformance in this case would have been even greater.
Also, there is no reason why an investor would have to monitor the performance of the S&P index on a daily basis to implement this strategy. Close approximations to the +25% and -10% milestones could likely work as well which might require perhaps a weekly glance at where the index is percentage-wise compared to where it was at the last low or high point. (Note: The last low point was 1267 back in early June, 2012. We do not yet know where the next high point will be recorded since it will only be of relevance after a new 10% drop.)
Some investors might wonder if they would always be able to afford to make additional purchases when a milestone drop was reached, especially if their net worth was down significantly as a result of the market dropping. But for investors who keep at least some of their portfolio in either bonds/cash, they would merely swap out of these alternative assets to make the required purchases.
For investors who might think of this strategy as too much like the "market timing" Hulbert's article advocates against, one should rather think of it as just another form of rebalancing a portfolio. Traditional rebalancing is based on bringing your portfolio back to some predefined percentages of stocks vs. bonds over certain predefined periods of time. The strategy outlined here, rather, allows you to make these changes whenever an external measure of stock performance exceeds or drops below a predefined level. In either case, the presumed longer-term advantage comes from buying low and selling high. Like with rebalancing, there is never a guarantee that the strategy will always put you ahead, but the odds greatly favor it over long periods.
And for investors who do decide to try to implement this strategy, remember this: The strategy is easy to think about in the abstract, but very difficult to follow through on when the time comes. For example, back in 2007 and 2008, the S&P reached five consecutive drops of 10% each, within about 12 months. How many among us would have the discipline to keep buying stocks after each new plunge? Likewise, it's even hard to step up to the plate after just one or two 10% corrections. But kudos should eventually await those who do.
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. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have positions in S&P 500 index funds other than SPY.