Using Economic Indicators To Time The Market - Part 3

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Includes: EEM, EFA, SPY
by: Paul Novell

Time for part 3 of the series on using economic indicators to time the market. In this post, I'll add a simple extension to the models analyzed in Part 2. If you haven't read the first two posts, you won't understand this one.

I'm just extending the model to include foreign stocks, foreign developed and emerging markets. This is much more reflective of real diversified portfolios - even with the heavy home bias amongst US investors. Let's see what that does to the results.

For foreign developed stocks, I'm using the iShares MSCI EAFE ETF (NYSEARCA:EFA) because it has the longest history. Similarly, for emerging markets, I'm using the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM). With the addition of foreign stocks to the mix, we'll do two things: replace the risk on period with an equal allocation to the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), EFA, and EEM vs. just investing in SPY. We can also use asset class momentum, just like in the AGG portfolios, and invest in the top performing ETF among the three. For the safe asset, we'll use IEF since it performs the best among the safe assets.

The results over the analyzed time period are below. Just as in the last post, these ETF have not been available for a long time thus limiting how far we can look back.

Click to enlarge

Two important things to note. In this time period, adding foreign equities reduces returns over a system that just uses US stocks. This is one of those cases where backtests can be quite misleading. Going forward, over the long term, would you expect these results to be the same? That global diversification would lead to lower results. And more importantly, would you be willing to invest based on that belief? I wouldn't. I would choose the more diversified portfolio. Also, notice that as you would expect, asset class momentum further improves results over a simple equally weighted diversified model.

Good stuff. We now have two globally diversified tactical asset allocation models based on the unemployment rate as the master risk on/off switch, with the traditional 200-day SMA (or 12-month absolute momentum, whichever you prefer) as the secondary risk off/on indicator. And for those that are following the UI indicator in real time, the latest unemployment rate was reported on June 3 at 4.7% down from 5.0% in the previous month. Thus, it remains below its 12-month moving average.