- Should I be in the stock market? Yes or No.
- What is the confidence level of that signal?
- If I am in the market, what should my allocation be?
Hi folks. This is my first blog post on Seeking Alpha, but my system has been running long enough now that I have finally reached the confidence level where I am ready to share it with others. In this post, I will outline the basic ideas of the system and the goals behind it, but in order to keep it proprietary and potentially available for selling subscriptions in the future, I won't be disclosing the rules behind it, except where they are already widely known. I also will not be sharing any backtested results, because I believe that they are too susceptible to curve fitting, so I tend to not put much faith in them. I also could imagine that some folks on here are smart enough to reverse-engineer the system from backtests, so I'll try to avoid that for obvious reasons.
First, a little background. In the past, I have struggled with following most momentum based market timing systems, because they tend to be of the "buy high and sell higher" school of thought. I have subscribed to many of them and backtested several of my own, but still couldn't quite get myself to follow them in real time with real money.
It might be easiest to explain why with an example. As I write this, it is early December of 2020, and SPY is hovering around all time highs. Not only all time highs, but highs that by almost any measure are way up in overbought territory. Wildly crazily insanely overbought territory. In short, good territory to be selling rather than buying.
On the other hand, if we imagine an intrepid investor who decided now to begin following many momentum style systems, he would be buying into this extended market. Since stocks are up, the system would be screaming "Buy!" so he would buy, and with a full allocation. But then what would most likely happen?
Of course, I don't know what will unfold in the second half of December and into January 2021 as I'm writing this (I'll write more in a few weeks after we see what happens just for fun), but I suspect that SPY is much more likely to pullback from here, or at least to trade sideways for awhile, rather than to continue what I call a "Buzz Lightyear" ("To infinity and beyond!") kind of rally like it has been lately.
Suppose that our imaginary investor isn't aware of such things though, and maybe never even looks at a stock chart, and blindly pulls the trigger, buying stocks in large allocations, because that is precisely what most systems would call for right now (the "what has been going up is likely to continue going up, so you should buy it" mindset). Further, suppose that I am right, and that the market suffers a pullback. Not a trend reversal mind you, just a plain vanilla short term pullback within a long term uptrend.
Our intrepid investor is inevitably going to suffer some emotional and financial pain during that pullback. No way around it. Even if his account is up 6 months later, during that short term pullback, he is going to suffer. Depending on his knowledge of market movements and his personal financial situation and emotional fortitude, he may even abandon the system at just the wrong time, leaving himself in a worse state than he was at the beginning. I know because I've been there.
For example, I have seen systems that send out signals like this:
1. The market has been up lately, so buy stocks.
2. The following month, stocks go down in a normal pullback within an uptrend. The system then says, bonds have been up more than stocks lately, so sell stocks and buy bonds.
3. Stocks resume their uptrend, bonds pull back, and the system says to get out of bonds and back onto stocks.
Of course, the result of all of that is, losing on both of the first two trades. Even if the system is a long term winner, it is extremely frustrating, and I would argue, avoidable.
After having experienced roller coasters like that in the past, I found that I couldn't take it, so I gave up and became a "buy, hold, and rebalance" or boglehead kind of guy. At least that way, when it was time to rebalance, I was able to sell a little of whatever had run up, and use that money to buy whatever had pulled back, which I found way more comfortable to live with emotionally. I like to buy low and sell high. That's just how I am wired.
Then, I began to read about a concept called "value averaging." If you aren't familiar with the concept, you can of course google it or search seeking alpha, but it basically involves scaling in and out of the market depending on whether it has gained or lost, in a mathematical way. That appealed to me even more, because it involved both buying low and selling high, as well as allowing your account to maintain a target growth rate. Now we're getting somewhere!
Putting it all together, I wanted to devise a system that achieved all of these three primary goals:
1. Being in the market during long term uptrends, and out during long term downtrends.
2. While in the market, to use a value averaging type of calculation to scale in and out depending on whether the market is temporarily overbought or oversold. In other words, to sell into short term rallies and to buy into short term pullbacks. Buy the dips and sell the rips.
3. Make the system easy to follow, on a schedule I am comfortable with.
Let's take each one of those goals separately, and I'll describe how I deal with each one of them. To be able to follow them, I calculate the status of the signals every Friday near the close. I decided that for me, weekly is more comfortable than monthly, since a lot can happen in a month, but I'm also not a day trader. I don't want to have to watch every tick all day every day. So each week, after looking at the status of the signals, I ask myself three questions:
Question 1: Should I be in the stock market? Yes or No. That is the first question I ask myself on Friday afternoons. To get the answer, I have two separate indicators that I look at. First, I follow publicly available (by subscription) signals from Paul Novell, where he determines the fundamentals of the economy, in order to determine if we are in a recession or not. I think he also incorporates a technical signal, but I mostly think of this as my fundamentals driven signal. Secondly, I also have my own technical signal that I use, and I won't be describing that, except to say that it meshes well with my value averaging calculations, and that it has done very well in avoiding recessions and major pullbacks, including the most recent covid one.
Question 2: What is the confidence level of that signal? This one is pretty simple. If Paul's signal is long, then I am too, with a half allocation. If my signal is long, then so am I, but again with only a half allocation. So, the two possible answers to this question are, Half or Full. Simple as that. If both systems are in the market, the answer is Full. If only one is, the answer is Half. Of course, if they both call for being out, we wouldn't get this far, because we would have stopped at the "No" answer in question 1.
Question 3: If I am in the market, what should my allocation be? This is where it gets more complicated, and interesting. This is also where it gets easier to live with if you're like me and hate being fully long when the market is way up, and love buying dips. On the other hand, if you suffer from serious FOMO, then you might not like it. For example, as I write this, the current signals are:
1. Should I be in the market? Yes.
2. Confidence? Full
3. Allocation? Zero.
Yes, you read that right. Question 1 says we are in an uptrend (pretty obvious if you look at a SPY chart from early December 2020). Question 2 says full confidence (both Paul's and my indicators agree). But, question 3 says I should be out. How could that be?
Well, the answer to that question is that we have simply gotten so overbought according to my value averaging calculation that, as we have been selling into this rally, we've reached the point where we have no shares left to sell. We are all out.
Basically, that is the purpose of this calculation. To determine, while in an uptrend, what percent of the account should be in stocks, and what percent should be out. In other words, to mathematically scale in and out of the market as it rises and falls.
This of course has two benefits. First, it reduces volatility. Because I am selling into rallies, when pullbacks happen, I am less allocated, therefore reducing drawdowns and volatility. Secondly, it increases returns. Even in a fairly sideways market, simply buying dips and selling into rallies creates return where simply holding the index goes nowhere, and in an uptrend, the same thing occurs, adding profits from each pattern of scaling in and out as the trend goes up.
The only time that it may temporarily appear to reduce profits is during times like we are in now in early December of 2020. There have been quite a few days lately when I have been all out, and SPY has continued to balloon on up. I'm ok with that though. I see these new highs as imaginary. There will be a pullback, or at least a sideways consolidation, either one of which will trigger my scaling back in accordingly. If you are the type who can't stand the idea of being out of the market when it is going farther and farther up into nose bleed altitudes, then this system is probably not for you.
If you're like me though, and enjoy locking in profits as you sell into rallies, and then buying back in at lower prices, then feel free to follow along. I'll try to update the signals every Friday afternoon, before I place the trades in my own account. In case I miss a signal for some reason, the system also works well trading on Mondays, so if I miss a Friday close I will try to catch up the signals over the weekend.
As usual on these financial blogs, I must caution you that I am not a financial advisor, and that I am not recommending any investment whatsoever in this system with real money. If you want to follow along by paper trading it, that would be a nice safe way to watch the story unfold. Also, there may be times when I am not able for various reasons to update the signals for awhile. I'll try to, but since I'm not offering this system as a paid subscription service but just for fun, I can't guarantee it.
That's another good reason not to follow it using real money. If I miss a signal and you're following along in a paper trading account, my best suggestion would be to just hold the allocation you currently have, then sell on the next close below SPY's 200 Day moving average (that's not the technical signal I use, but it should keep your paper trading account out of too much trouble).
Hope you enjoy! Fell free to leave any comments or questions and I will try to answer when I am able to check back.
Again, to reiterate, here are the current signals:
Should I be in the stock market? Yes.
See you this Friday!
Analyst's Disclosure: I am/we are long SPY.
I will be either long SPY or not, as indicated in the latest post. I will also be long various bond funds.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.