Cyclical Market Timing: The King of Passive Investment Strategies

Includes: DIA, QQQ, SPY
by: Erik McCurdy

Many commentators on financial television have lamented the “death” of buy-and-hold as a viable investment strategy, citing negative returns for stocks over the past decade. However, this sentiment reflects a lack of understanding of secular market cycles. Of course stocks have lost value over the past ten years: they have been in a secular bear market since the year 2000. When you analyze their performance during the previous secular bull market from 1982, stocks (as defined by a broad index such as the S&P 500) produced a compound annual return of nearly 17% over 18 years.

As far as passive investment strategies go, buy-and-hold has traditionally performed very well over the long term, but timing certainly plays a large part in its success. Given that limitation, perhaps a secular market timing strategy that is long stocks during secular bull markets and then moves into bonds for the duration of secular bears would outperform it? Successful secular market timing would certainly avoid the typically large drawdowns that occur during bear markets, but it would also miss out on the large cyclical swings within each secular trend.

Perhaps a cyclical market timing strategy would outperform both buy-and-hold and secular market timing, unless it were unable to overcome the constant (relatively speaking) loss of assets to capital gains payments and the consequent negative impact on the compounding effect. Providing there was a reliable way to identify both secular and cyclical trend inflection points, which of these three passive investment strategies would perform the best? Let’s find out by having a theoretical competition.

In order to adequately judge the performance of all three strategies, we would need to use a time period that encompasses multiple secular cycles. If we go back 70 years and start the competition in 1940, we would cover two complete secular bull markets (1949 to 1968 and 1982 to 2000) and three bear market periods (1940 to 1949, 1968 to 1982 and 2000 to 2010). In order to provide a fair starting point for all three strategies, we will move slightly forward to June 1942 when the first cyclical trend inflection point of the decade occurred, giving each strategy $10,000 of initial principal. As you would expect, their individual strategies are relatively simple. Buy-and-hold will simply purchase the S&P 500 index and then do nothing until the end of the competition. Secular market timing will buy the S&P 500 index at the beginning of each secular bull market and then close that long position at the beginning of the subsequent secular bear and move into high quality bonds.

Finally, the cyclical market timing strategy will go long the S&P 500 at the beginning of every cyclical uptrend and then flip to a short position at the beginning of every cyclical downtrend. All dividends will be reinvested across all strategies (making tax payments upon receipt of the dividend payment), and the highest capital gains rate will be applied at the close of every profitable trade.

Additionally, the cyclical market timing strategy will have the added impediment of making dividend payments while it carries an open short position. The individual trades themselves will be made using our Secular Trend Score (STS) and Cyclical Trend Score (CTS), both of which identify highly likely inflection points in their respective trends. The STS has correctly identified every secular turning point since the beginning of the Great Depression secular bear in 1929, and the CTS has identified over 90% of the cyclical turning points, so all three strategies will be operating under near ideal conditions for their respective trading processes. Now let’s review the results.

The buy-and-hold strategy executed only one trade, buying the S&P 500 in June 1942 and selling in June 2010.

The net value of the portfolio at the end of the competition was $3,673,682, a compound annual return of 9.1%.

The secular market timing strategy held the S&P 500 index from July 1949 to May 1969 and from October 1982 to October 2000.

The rest of the time, the secular timing strategy held a balanced mix of government treasuries and high-quality corporate bonds. The net value of its portfolio at the end of the competition was $3,476,223, for a compound annual return of 9.0%.

Finally, the cyclical market timing strategy executed 28 trades from June 1942 to June 2010, sixteen long trades and twelve short trades. Thirteen of the sixteen long trades were profitable with an average gain of 97%, while eleven of the twelve short trades were profitable with an average gain of 18%. Two long trades were closed with small losses of 5% each.

The cyclical market timing strategy finished well ahead of the other two with a net portfolio value of $23,666,072 and a compound annual return of 12.1%.

All three strategies are relatively passive and require very little monitoring. The key to successfully implementing the market timing strategies, of course, is to have a reliable way to identify highly probable cyclical and secular inflection points, like our CTS and STS. It might be surprising to some that buy-and-hold actually beat secular market timing (granted, it would certainly be possible to improve the performance of the secular timing strategy by taking a more active role in the management of the bond positions during secular bear markets, but the competition would no longer be a truly apples-to-apples comparison of passive strategies). After all, the idea of getting out at the end of each secular bull market and then getting back in at the start of the next one would seem like a logical way to maximum long-term returns.

However, the reason buy-and-hold is able to compete so well is through the power of compounding. The secular market timing strategy loses a large percentage of its assets at the end of each secular trend to capital gains, assets that no longer contribute to compounding moving forward. Buy-and-hold compounds every cent of the original principal and reinvested dividends. It is actually a testament to the strength of the cyclical market timing strategy that it is able to overcome the loss of so much compounding fuel (28 trades) and still beat the other two strategies so handily.

Disclosure: No positions