Imagine you find an indicator predicting all 8 recessions in the United States since 1950, without giving a wrong positive on the whole period. Is it the holy grail of market timing? Not really. In statistics, being right 8 times out of 8 implies being right 67% of the time with a 95% confidence interval. In other words, there is a 95% probability that the indicator's accuracy is at least 67%. How much of your portfolio would you bet on an indicator that may be wrong 33% of the time?
Data to test the usual market timing indicators are available for about a century, in the best cases. The United States has crossed 22 recessions since 1900. This data sample is too small to claim that one timing indicator is better than another, or safe enough to make a large bet.
From Market Timing to Systemic Risk
Multi Timing Scores are multi-valued indicators focused on a long-term investing horizon, including the 4 main fields of market analysis: economics, fundamentals, technicals, sentiment. They count bearish signals among a set of elementary indicators based on economic data and stocks. The simplest version MTS4 is calculated as follows:
- If the unemployment rate is above its value 3 months earlier, then a=1; else a=0.
- If S&P 500's EPS estimate is below its value 3 months earlier, then b=1; else b=0.
- If S&P 500's 50-day sma is below the 200-day sma, then c=1; else c=0.
- If the 52-week sma of the average short interest in S&P 500 stocks is above the 104-week sma, then d=1; else d=0.
MTS4 is the sum a+b+c+d, resulting in an integer between 0 and 4. The 4 analysis fields are represented: a for economics, b for fundamentals, c for technicals, d for sentiment. Readers willing more insights on these indicators can go here and here.
MTS4 does not aim at making predictions, but at telling when the ecosystem is favorable to black swans. It is a risk indicator. The best way to understand it is an analogy with the avalanche danger scale used by skiers and snowboarders. In my years of ski-mountaineering racing, I was training in the mountains every weekend between December and April in all conditions.
The summits and slopes were always chosen based on the avalanche danger scale. Every additional point in the scale narrows the choice, depending on the inclination and orientation. Adapting exposure to risks: the same words are used in mountaineering and investing. In both activities, some people think that the choice is binary. You go, or you don't go. You are in the market, or you are out of it. Other people make scaled decisions. Now, here is an example of how MTS4 can help you make scaled decisions.
A simple ETF strategy based on MTS4
I will give the strategy rules first, then explain the logic, and finally show a backtest. The portfolio is composed of 3 ETFs depending on MTS4 value.
For MTS=2, holdings are MDY, QQQ, IEF.
For MTS=3, holdings are MDY, IEI, IEF.
For MTS=4, holdings are SHY, IEI, IEF.
There are 3 ideas in this model. The first one is obvious: adapting the stock/bond ratio to market risk.
The second idea is to take 3 stock ETFs with an increasing risk. The riskiest one is switched to bonds at a low risk level, the middle one at a medium risk level, the safest one only at a high risk level.
The third idea is to include shorter-term bonds when the risk goes up. It increases the proportion of lower volatility assets when violent market gyrations are the most likely.
In the next simulation, positions are rebalanced once a week and dividends are included. The starting date (1/1/2001) is chosen according to data availability and MTS4 look-back period.
Even if it is not a guarantee for the future, it is almost 5 times SPY's total return in 15 years for about half the drawdown. MTS4 is open source: it can be calculated with the specifications above. I also send it for free every week. Just ask me here if you are interested.
A second article will make this strategy even better: a similar return, a drawdown reduced at 8% and a Sharpe ratio above 1.5. All that without optimized parameters, just adding 2 rules based on good old market common sense. If you don't want to miss it, click Follow at the top of this page.
Data and charts provided by portfolio123.
Disclosure: I/we 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.