Back Testing a Popular Market Timing Strategy
If you’re a long-time reader, you know that I believe a portfolio should be based on a financial plan that follows these guidelines –
Globally diversified
Rebalanced regularly according to an investment plan
Low-cost and tax-efficient
And most importantly, an investment plan that doesn’t include trying to time the market. The data overwhelmingly shows that no one can accurately and consistently predict the market.
Whenever there is a long bull market, this strategy sounds great. But when we are in the middle of a bear market, sitting on our hands can be unbearable. This is also the time when you’ll start hearing about market timing strategies – often from technical analysts. A technical analyst is someone who trades based on charts and whether there is momentum in either direction. I was recently listening to one of these analysts describe timing the market as a simple supply and demand equation. If there is less demand than normal for stocks, you should be selling. Essentially, once prices have started to fall and there is momentum going in that direction, sell. Don’t fight gravity. Then, once prices have bottomed and prices have started to recover and there is momentum moving up, buy.
It sounds simple enough, but I know the data does not support this. So, I decided to stress test it. I back-tested the following strategy – one that follows a popular strategy following recent market trends.
If over the past 30 days, the S&P 500 ETF (SPY) has NOT fallen by 10% or more, continue to own stocks (SPY).
If over the past 30 days, the S&P 500 ETF (SPY) HAS fallen by 10% or more, short the S&P 500 (SH). Shorting the market is where you essentially bet against the market, profiting when the market goes down.
Not surprising, there was some serious pain avoided during market crashes. The first picture is the Financial Crisis from October 1, 2008, through March 9, 2009, where the marketing timing strategy (white line) is up 11% and the S&P 500 (pink line) is down about 41%. The second picture is the Covid crash from January 1, 2020, through March 23, 2020, where the marketing timing strategy is up 15% and the S&P 500 is down 31% (See assumptions and disclaimers).
On the flip side, the market timing strategy was never able to get the investor back into the market within a reasonable time and during the recoveries, the market crushed the market timing strategy. The first picture below is the Financial Crisis recovery from March 9, 2009, through the end of 2009, where the marketing timing strategy (white line) was up 10% and the S&P 500 (pink line) was up 67%. The second picture is the Covid Crisis recovery from March 23, 2020, through the end of 2020, where the marketing timing strategy was up 5% and the S&P 500 was up 70% (See assumptions and disclaimers).
This makes sense - the bottom in a stock market crash is messy and filled with a lot of noise. For example, during the bottom of the Covid crisis, market pundits were calling for the next great depression, which meant possibly another 50% decline in the S&P 500. During the bottom of the 2008 financial crisis, market pundits were discussing the possibility of a complete collapse of the U.S financial system, meaning a possible 100% collapse in some stock prices.
During these times, you might have days where the stock market is up 10% and then down 8% the next. There are a lot of false tops and false bottoms along the way. It is hard to get a sense of which way the market is going and by the time you do, it’s too late and you would have been better off staying put. In addition, there are many false tops (i.e the market is down 10% or 20% and feels like it can only go lower, but then recovers quickly). Of course, eventually, the big drop will occur, but again, no one can know when this will occur. This is precisely why timing the market is just so difficult – it requires two accurate guesses – when to get out AND again when to get back in.
Over the long haul, staying put in the market paid off substantially more than getting in and out based on which direction the market had recently moved toward.
From the start of the Financial Crisis through August 17th of 2022, the Market Timing strategy (yellow line) is up 111.60% and the S&P 500 (pink line) is up 289.92% (See assumptions and disclaimers). Despite avoiding the nastiest financial crisis any of us have ever lived through and a market panic during the pandemic, the investor staying the course is the winner by a long shot.
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.