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How To Use Market-Timing While Staying Fully Invested

|About: SPDR S&P 500 Trust ETF (SPY)

The goal of a market-timing strategy is to determine with some degree of accuracy what the market will do next, and then position your portfolio accordingly.

For instance, some proponents of market-timing will stay fully invested as long as the S&P 500 index (NYSEARCA:SPY) is above its 200 day moving average but then sell holdings, or even go short, when the index falls below the 200 day MA. Other market-timers will follow sentiment surveys and begin selling off stock when too many investors are bullish…which is commonly viewed as a signal that a downturn is imminent as the market is saturated and there is not enough new money to drive prices higher.

Market-Timing Approach: S&P 500 Earnings Estimate

One approach that I have used successfully is with the S&P 500 earnings estimates. The theory is quite simple:

  • When the future earnings are trending up, the market generally follows.
  • However, when analysts begin cutting future earnings deep enough and over a prolonged period of time - whether it is in response to current or predicted catalysts - this often goes hand in hand with the market trend.

You can see the clear correlation below between the price action of the S&P 500 index and the trend of the S&P 500 earnings estimate since 1999.

Testing the Theory and Establishing Rules

Before we take this market-timing concept further, we will run a couple of simulations to see how this method has performed over the past 14 years.

First, we need access to S&P 500 estimate revisions. All data and strategy testing will be carried out compliments of Portfolio123. We have the option of S&P 500 trailing, current year, next year, blended current year or blended quarters (a mix of 2 trailing and 2 forward) for our data set. In this example I will use the S&P 500 current year EPS estimate.

Next, we need to establish the actual signal that will prompt us to adjust our portfolio. We will use a combination of moving averages (5 and 21 week) on the earnings data.

  • When the short-term moving average is above the long-term, we stay invested.
  • When the short-term is below the long-term, we switch to cash.

This simple strategy is programmed into the screener with this rule and the following results:

  1. sma(5,0,#SPEPSCY) > sma(21,0,#SPEPSCY)

Soft Market-Timing

However, I have never liked the 'all in' or 'all cash' approach that many market-timing strategists advocate. While I believe that there is a time to lower exposure to the market and raise cash (a discussion for a future article), I prefer to use 'soft market-timing' where I favor certain stock factors over others.

For instance, when the market is giving a bearish signal based on the S&P 500 EPS rule, there are certain stock characteristics that are preferred such as lower beta, a tighter range in earnings estimates and lower debt to equity ratios. When market conditions are bullish we may favor growth, deep value and positive earnings revisions.

So instead of switching from stocks to cash with our market timing rules, we rotate between stocks - even in the same sector - but with different risk characteristics. For this article we will use the P123 Multi-Market Rank (compliments of Portfolio123) which ranks stocks on 34 different characteristics and recommends a different set of stocks depending on the current market conditions.

Below are some examples of how this we can practically use this 'soft market-timing' system to enhance a fully invested strategy.

Investing in the Materials sector in the S&P 500 with associated stats:

Investing in the 'best 10 stocks' in the Materials sector in the S&P 500 using P123 Multi-market Rank:

The Sharpe and Sortino ratios basically double while drawdown is greatly reduced and annualized gain increases by 5% annually.

The effectiveness of the market-timing rules has variance between sectors, but in general it increases annual performance and decreases volatility and loss in bad markets. There are many ways to use this type of market-timing ranking system. One of my more defensive strategies utilizes Utility stocks. Below is the strategy that uses generated profit to buy the best utility value stocks. This strategy holds the same group of utility stocks through thick and thin.

It is still a decent system with an annualized return of 11% with virtually no turnover and a max loss of 42.7% during 2008/2009 as opposed to the market drop of 56.7%. Notice the difference though once I switch the ranking system over to 'market-timing' and add minimum ranking levels when stocks should be bought and sold.

Not only does our annual gain increase dramatically but our downside is almost cut in half with a risk/reward ratio 2.5x greater than previous. True, our turnover increases somewhat but this is more than compensated for.

Soft Market-Timing Summary

Many investors choose to stay away from market-timing and take the passive approach by holding a portfolio of high quality stocks through thick and thin. Other investors who use market-timing will leverage in bull markets while selling or shorting in bear markets. I prefer an approach somewhere in the middle allows me to stay invested in bull or bear markets but where certain stock characteristics are preferred in each market. While this sort of sophistication was only available through hedge funds or quant funds with high management fees in the past, this sort of strategy is now available to any self-directed investor with the desire and time.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.