Avoid Crashes With This Simple Market-Timing System

If the stock market climbs a wall worry, then the bull market is far from over and investors have significant gains to look forward to!

Stock-market bears like David Stockman and Ted Bauman are sounding the alarm about stocks – both in terms of fundamental overvaluation and technical death crosses. Some say a bear market has already started, whereas others are uncertain as to timing but nevertheless expect a stock-market crash of 50%-70% in the ambiguous “future.” 

“Doom and Gloom” Sells, But Only Enriches the Prognosticator

Permabears such as John Hussman and Albert Edwards have been scaring investors out of the stock market for years – much to the detriment of their long-term wealth. As financial blogger Barry Ritholtz has written, many investors have completely missed the huge “once-in-a-generation” stock-market rally that has occurred since March 2009.

These unfortunate souls kept their money in cash because they listened to doomsday pessimists. It may titillate, but following such fear mongering is damaging to your long-term wealth:

People I speak with who have missed this huge move have been consuming a diet of doom and gloom. If you think that it doesn’t affect you, you’re kidding yourself. Constantly reading about hyperinflation and the collapse of the dollar and the end of the United States as a world power and the student loan crisis and the Chinese are taking over the world and … STOP! Right now.

It is recession porn, a focus on the negative that is a leftover effect of the crash and Great Recession.

Go through your bookmarks, and delete all of these sites: the goldbugs, the end-of-worlders, the doom-and-gloomers, the outraged Fed critics. They all have agendas that typically have to do with selling you subscriptions or advertising. They are not at all concerned with your returns, your portfolio or your retirement.

Although stocks have suffered two 10% corrections this year, signs of an impending major top remain scarce. An analysis of current conditions suggests a still-healthy bull market and I completely disagree with those doom-and-gloomers that say market crashes come without warning.

Mebane Faber is a Quant

All one has to do to avoid getting hurt by a stock-market crash is to follow a simple market-timing system based on the 10-month moving average (since there are about 20 trading days per month, the 10-month MA is similar to the 200-day MA). This system was developed by Mebane (pronounced “meb-in”) Faber, a 2000 graduate of one of my alma-mater schools (University of Virginia) who majored in both engineering and biology.

Yale and Harvard Have Outperformed the Rest of Us

The market-timing system is associated with Faber’s 2009 book entitled The Ivy Portfolio: How to Invest in the Top Endowments and Avoid Bear Markets. The gist of the book is that individual investors typically limit their portfolios to two asset classes: common stock (e.g., S&P 500) and bonds (e.g., 10-Year U.S. Treasury notes). In contrast, the multi-billion-dollar endowments at the Ivy League universities of Yale and Harvard invest in many “alternative” asset classes, in addition to stocks and bonds, that significantly improve investment performance. The Ivy League investment returns over a 25-year period speak for themselves:

June 30, 1984-June 30, 2008

Portfolio

Compounded Annual Return
(Higher is Better)

Annual Volatility
(Lower is Better)

Sharpe Ratio (Return/Volatility)

S&P 500

11.9%

16.2%

0.73

Yale Endowment

16.6%

10.8%

1.54

Harvard Endowment

15.1%

9.9%

1.53

Source: Bloomberg, The Ivy Portfolio

Perhaps even more impressive are the relative performance of the Yale and Harvard endowments during the horrible bear market between June 2000 and June 2003 when the S&P 500 lost 30%. In contrast, Yale generated a 20% positive return and Harvard was up 9%.

Diversification Among Non-Correlated Asset Classes Improves Investment Returns

Of course, Ivy League endowments have access to the best hedge funds, private equity funds, and venture capital funds, all of which are inaccessible to the average investor. But Faber, not to mention Yale Chief Investment Officer David Swensen, believes that the average investor can go a long way towards mimicking the diversification benefits of alternative asset classes by utilizing low-cost exchange-traded funds (ETFs). In a research paper, Faber constructs an equally weighted (i.e., 20% each) portfolio composed of five asset classes:

  • US stocks (VTI)
  • Foreign stocks (VEU)
  • Bonds (BND)
  • Real estate investment trusts (VNQ)
  • Commodities (DBC)

Swensen’s model portfolio substitutes inflation-protected bonds (TIPS) for commodities and separates emerging-market foreign stocks from developed-market foreign stocks, but the principle is the same. Faber then compared the performance of his 5-asset portfolio compared to the S&P 500 over the 40-year period between 1973 and 2012 (indices were used for periods when ETFs did not yet exist):

1973-2012

Portfolio

Compounded Annual Return
(Higher is Better)

Annual Volatility
(Lower is Better)

Sharpe Ratio (Return/Volatility)

Maximum Drawdown

S&P 500

9.70%

15.7%

0.27

-51.0%

Faber 5-Asset Portfolio

9.92%

10.3%

0.44

-46.0%

Volatility and Sharpe ratio are much improved, but the annualized return and maximum drawdown (i.e., peak-to-trough decline on a monthly basis) are disappointingly similar. A large portion of the disappointment can be traced to the severe bear markets of 1973-74, 2000-03, and 2008-09 when correlations among asset classes increased markedly at the worst possible time, resulting in all declining in price at the same time. Faber uses 2008 as a prime example:

The normal benefits of diversification disappeared as many non-correlated asset classes experienced large declines simultaneously. Commodities, REITs, and foreign stock indices all suffered drawdowns over 50%.

If only there were a way to avoid exposure to risk assets during the most severe bear markets, the problem of converging correlations could be avoided and the diversification benefits of different asset classes with normally low correlations could be fully realized . . .

Market Timing Using Moving-Average Crossovers Avoids Crashes

Market timing to the rescue! Faber demonstrates that an extremely-simple trend-following system based on the 10-month moving average dramatically reduces the maximum drawdown of any asset class and increases annualized rate of return to boot.  For each asset class:

  1. Wait until the market close on the last trading day of a calendar month.
  2. If the asset’s current market price is above its 10-month moving average, invest a full allocation in the asset class for the next month.
  3. If the asset’s current market price is below the 10-month moving average, invest in either cash or intermediate-term U.S. Treasury notes (anywhere between 5-10 years).
  4. Ignore price fluctuations above or below the 10-month MA during the month – all investment decisions occur only once at the end of the month.

That’s it. The results are amazing. As Faber states, the diversification benefits of a five-asset portfolio are turbocharged by market timing with moving averages:

The additional advantages conferred by timing are striking. Timing results in a reduction of volatility to single-digit levels, as well as a single-digit maximum drawdown. Drawdown is reduced from 46% to less than 10%, and the investor would have only experienced one down year of less than -1% since inception in 1973.

You read that right – over a 40-year period, the portfolio lost money in only one calendar year (2008) and then only by -0.59%! Isn’t the ability to sleep at night with such peace of mind incredibly valuable? Of course, hiding your cash in a mattress also would significantly reduce the maximum drawdown and prevent nominal market declines in any calendar year, so the market-timing system is only useful if the annualized return is similar in magnitude to a buy and hold portfolio. Fortunately, it is not just similar – it is higher:  

1973-2012

Faber 5-Asset Portfolio

Compounded Annual Return
(Higher is Better)

Annual Volatility
(Lower is Better)

Sharpe Ratio (Return/Volatility)

Maximum Drawdown

Buy and Hold

9.92%

10.3%

0.44

-46.0%

Market Timing Using 10-Month Moving Average

10.48%

7.0%

0.73

-9.5%

If you’re worried that the humongous decrease in the maximum drawdown only occurs because of commodities or bonds and says nothing about the potential for a stock crash, consider this: since 1900, during the 8 calendar years when the S&P 500 (or its large-cap index equivalent prior to 1957) lost 20% or more, the most-negative return an investor in the S&P 500 using the 10-month MA system ever experienced was -4.6%:

Eight Worst Years
for S&P 500 (or equivalent) Since 1900

Buy and Hold

Market Timing Using 10-Month Moving Average

1931

-43.9%

1.4%

2008

-36.8%

1.3%

1937

-35.3%

-7.7%

1907

-29.6%

-0.1%

1974

-26.5%

8.2%

1917

-25.3%

-3.0%

1930

-25.3%

2.5%

2002

-22.1%

-4.6%

After seeing this table, how can you ever become scared reading permabears? If they predict the S&P 500 is going to suffer another 40% decline similar to 1931 or 2008, you can just laugh and say “bring it on!” because you will be confident that the 10-month moving average system will totally protect you.

Avoiding the “Big Loss” Does Not Sacrifice High Investment Returns

And don’t feel bad that you will be sacrificing any upside for this peace of mind because you won’t be. Between 1901 and 2012, the compounded average return of the S&P 500 using this market-timing system is 10.2%, higher than the 9.3% buy-and-hold return. Given these fabulous results, why doesn’t everyone trade stocks this way?

Discipline and Long-Term Thinking Is Needed to Follow the System

I think the reason the market-timing system is underutilized is because its primary benefit is in avoiding the rare – but deadly – crash, which means that most of the time the system appears unnecessary and a hindrance.

The market-timing system can significantly underperform buy-and-hold stock investing during bull markets and trails the returns of buy-and-hold investing slightly more than half the time over the past century. After a few years of underperforming, market-timing investors “give up” and decided to chase higher returns, which usually occurs just before a bear market hits and the market-timing system starts to outperform.

Most recently, the market-timing system has underperformed buy-and-hold for four consecutive years (2009 through 2012). How many investors have the discipline to withstand four consecutive years of underperformance and still stick with the system?

Over the Next Few Years, Market Timing Should Shine!

Since 1973, market timing has underperformed buy-and-hold for four consecutive years two other times: 1977-80 and 1983-86. In both instances, the following four years saw market timing outperform buy-and- hold. If the stock market stays true to form this time around, the next four years (2013-16) will see market timing outperform buy-and-hold yet again. Are you ready?

It’s easy to follow the market-timing system and right now, the system recommends staying fully invested in U.S. stocks, foreign stocks, and real estate investment trusts (REITs), while cashing out of commodities and bonds. Until stocks fall below the 10-month moving average, permabears should be completely ignored.

Lastly, Faber has an interesting video on his website that suggests ways that the market-timing system can be modified to produce even better investment performance. Promising modifications include: (1) using a 9-month or 14-month moving average instead of a 10-month; (2) expanding the number of asset classes from five to 10, but then only investing in the four asset classes with the strongest price momentum; and (3) using intermediate-term bonds instead of cash to park the sale proceeds of asset classes that are currently under their moving average.

Even without any complicating changes, however, it’s nice to know that the original Ivy market-timing system enables you to easily avoid stock-market crashes without sacrificing the high-return benefits of long-term stock investing.

But what if I told you that I’ve developed a proprietary investment method that makes money in up or down markets, in economic expansions or downturns? Would you be interested? Well, you can access my system today.

As chief investment strategist of the premium trading service Velocity Trader, I’m making my followers a “bet.” I’m promising to deliver 24 triple-digit winning trades over the next 12 months. If not, I’ll cut you a check for $1,950! That’s how confident I am in my system. To take me up on my promise, click here now.

 

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