In this post I’ll summarize a recent and very comprehensive study on market timing. It is probably the most comprehensive and robust look at market timing yet. Market timing is one of the biggest potential problems and complaints with TAA portfolios as I highlighted recently. Everyone wants a definitive answer – does it work or doesn’t it? As you might expect, there is something in the results for everyone, the die hard buy and holders and the die hard market timers. For those interested in implementing TAA portfolios there are several surprising findings in the study that are very applicable to a TAA approach with the potential to significantly improve results. Let’s dive right in.

First, a few notes about the study. You can read the entire study for yourself here . I highly recommend a detailed reading for advanced practitioners of TAA portfolios. The study is very recent, draft published in March, last updated a few days ago. The study is extremely robust and comprehensive. It uses monthly data on the SP500 index for a 155 year period – from Jan 186o through Dec 2014. The tests are conducted out of sample. The study includes the effect of transaction costs (0.25% one-way transaction costs). It tests 6 market timing rules over the study period – from the simple absolute momentum rule, to the well know simple moving average, to more complex rules like the double cross-over method. It tests the market timing rules not only over the whole study period but also over more realistic investment horizons, 5 and 10 year periods, using familiar portfolio stats such as sharpe ratio and sortino ratio. All right, enough about the technical details. Let’s get to the results.

The first set of results are for the entire out of sample test period. The study parameters were determined in a 10 year in sample period, then applied to the 1870 to 2014 out of sample period. Below is the results table showing mean monthly returns (not compounded) and other descriptive statistics.

I only include the 3 market timing rules that showed statistically significant results (the bold figures in the table); absolute momentum, reverse exponential moving average, and the classic simple moving average. In short, all three of the market timing rules outperform the market on a risk adjusted basis (sharpe ratio) over the study period (145 years, 1870 to 2014). Of the three market timing rules, the absolute momentum rule has the best risk adjusted performance. The simplest is often the best approach. Also, note that the absolute moment rule is the only one with positive skewness (in a very simples sense – more data points above the mean than below the mean), and significantly greater than the market. Before I move on to a better way to look at the results, let’s look at how the study determined the optimal look back period for the market timing rules.

The difference between the Rol (rolling) and Exp (expanding) columns in the results table above is the different method to determine the lookback period for each rule. The expanding rule looks at the entire study period to determine how many historical months to use for the market timing rule, e.g 10 month SMA. The rolling rule uses a rolling window of historical data. Ideally, the two would be the same. i.e. the optimal look back period would be stationary, it would be a single number. But it isn’t. The optimal look back period varies over time. The chart below shows the optimal look back period, in months, for the momentum rule and the simple moving average rule over time. The average for the momentum rule is 7 months and for the simple moving average it is 10 months but there is significant variation.

Now, let’s turn to a better way to look at the results. There are two important improvements to the results presentation. First, the presentation of annualized returns compared to the market and the returns over more realistic investment horizons (5 year and 10 years). After all, who has a 145 year investment horizon.

The next results presentation is much more applicable to real world investors. In these sets of results, the study looks at the annualized performance vs the market for the various market timing rules over 5 year investment periods and over 10 year investment periods. I also limited the presentation to the three rules that showed statistically significant results. Below is the results table.

The three market timing rules all outperform the market (positive mean values) and that outperformance increases the longer the investment period. For example, over a 5 year horizon, the absolute momentum rule outperforms the market on average by 1.95% per year using a rolling estimate of the optimal look back period. However, note that even over 5 and 10 year investment horizons there is still a significant chance the market timing rule will underperform the market. Over a 5 year horizon, only the absolute momentum rule has an out performance probability over 50%. Over a 10 year horizon, all three rules have a greater than 50% chance of outperforming that market, with all but one approaching a 60% chance. I also think it’s instructive to look at how the performance vs the market varies over time. Below I show the annualized performance over 5 year horizons relative to the market for the absolute momentum rule over the study period.

Notice that the greatest out performance versus the market for the momentum rule has come during the worst bear markets. It’s similar for the other rules. The worse the bear market the greater the out performance. That’s what you would expect and hope from a market timing rule I think. Of course, for that benefit you would have had to tolerate long periods of under performance. Whether it’s worth implementing market timing is entirely up to the investor and their goals. I would argue that at a minimum, market timing will probably help investors stick with their investment approach and thus lead to better returns and that for retirees where the biggest risk is big negative returns, market timing leads to higher SWRs versus buy and hold.

I’m going to leave the concluding remarks on this post to the authors of the study. There is a ton that could be said about these results but I think they sum it up nicely and conservatively.

*
“…we did find support for the claim that one can beat the market by timing it. Yet the chances for beating the market depend on the length of the investment horizon. Whereas over very long-term horizons the market timing strategy is almost sure to outperform the market on a risk-adjusted basis, over more realistic medium- term horizons the market timing strategy is equally likely to outperform as to underperform. Yet we found that the average outperformance is greater than the average underperformance.”
*

Been reading your wife’s blog a long time and just discovered your blog.Enjoyed the option strategy archival blogs.I too, am retired and have been generating income mostly by covered call writing in my IRA.I live off my pensions so the tax free IRA is a good way to increase my assets,have hit a 13% rate of return over last 12 years with relative safety.

The proliferation of weekly equity options has made the job easier and the premiums fatter, in my opinion.Have you developed any strategies that use the abundance of weekly options as a tool?

We are snowbirds and spend 3 months every winter roaming the Southwest.Perhaps our paths will cross someday.

My folks came from Sverdrup Denmark and I have traced them back to the early 1600s.I know Nina is Danish.

Hi Chas, nice to meet you. I don’t trade options anymore. I switched to being a 100% quant investor.

Paul

Wow this is a great review of a very dense and mathematical paper (which I read in its entirety) that arrives at some very interesting and reassuring conclusions. The authors query in their research whether market timing in different iterations and over various timeframes beats the raw market averages. And although their conclusions are mixed they generally find that by employing a simple moving average timing strategy investors will likely outperform slightly more often than underperform and the degree of outperformance will exceed the degree of underperformance creating a positive skew. A flaw of their methodology is that they appear to use 5 and 10 year blocks of time rather than 5 and 10 year rolling intervals as their data sets, but nevertheless an extremely robust paper. Their caution is that underperformance can be durable and protracted and that investors don’t sometimes have time horizons long enough to prove the method. The outperformance of the market timing portfolios may come solely by sidestepping major downturns. I don’t think it should be the focus of most investors to beat the averages, rather to obtain near equity like returns with less risk and less drawdown, and these simple trend following methods are well suited to accomplish this IMO.

Hi David, I agree totally with your last comment.

Paul

P.S. I do think the study uses 5 and 10 year rolling periods. Regardless, it is a robust look at market timing.

Paul,

Great summary on your part! I read your post and skimmed the study and will have to go back and review in more detail when I get time.

For me, I guess the initial take-aways are that the study generally agrees with Meb Faber’s approach for his TAA models and Gary Antonacci’s for his Dual Momentum.

Faber asserts that SMA timing often has a much bigger effect on volatility and draw-downs (instead of the actual return) so that the risk adjusted returns are much better. The study found an “optimal” SMA parameter of 10 months, which is what Faber uses. Also in the study, using the “straight forward” moving average where the price changes are equally weighted, produces the best performance in the out-of-sample tests. This is what Faber uses in his TAA approaches.

The study also backs up Gary Antonacci and his Dual Momentum Investing (thanks to you for pointing out this book to your blog readers and posting the allocation monthly). Antonacci uses Absolute Momentum (as one part of the dual momentum) and points out how Absolute Momentum reduces down-side exposure which improves risk adjusted returns. This is also shown in the study. Antonacci recommends a 12 month look back period although the study recommends 7 for the US Stock Universe. I can’t recall, but think Antonacci may have recommended 12 months since it was “best” for all asset classes.

Timing Battle:

Absolute Momentum(Antonacci) vs SMA(Faber):

In his book, Antonacci says 12 month Absolute Momentum is better then using a 10 month SMA and had a comparison. Although, the performance results in his book were very similar, I think Antonacci’s biggest point was not performance, but instead that the 12-month Absolute Momentum had less transactions (and thus less trading costs) then the 10-month SMA.

The study results look like it gives an edge to Absolute Momentum. What do you think?

Thus, as you point out in your quote above “As you might expect, there is something in the results for everyone, the die hard buy and holders and the die hard market timers.” – for someone using Fabers TAA or Antonacci’s models, there are certain results from the study that makes one feel it is “OK” to do so.

Lastly, your quote : “For those interested in implementing TAA portfolios there are several surprising findings in the study that are very applicable to a TAA approach with the potential to significantly improve results.”

What was the biggest surprise to you?

Thank you for all your efforts!

Brian, the results definitely concur with both Antonacci’s and Faber’s. So, that’s good.

The biggest surprise, although I had seen some of this in my backtests, was that absolute momentum is the best market timing rule.

Also, just how long the periods of under performance can be, e.g. there have been 20 year periods where market timing under performed. I will be looking at switching from SMA to momentum rules in my portfolios.

Paul

Hi Paul,

Paul,

Thanks for a very interesting post.

Regarding the superiority of absolute momentum, have you read the author’s (Zakamulin’s) earlier piece that discusses best lookback periods? It appears to vary by asset class ( S&P = 5 months; LT bonds = 12 months). Do you plan to implement any of this in your switch to the MOM system or do you plan to use the same”average” lookback period for all assets? If not, are you aware of any source/study to help determine the optimum period for each asset class (like all 13 classes in GTAA 13)?

Thanks!

River

Hey River,

Yes, I’ve read Zakamulin’s earlier piece. There is no one best lookback period for any asset class across time. Yes, there are different averages for each asset class that worked the best for an entire period but that doesn’t help for 5 to 10 yr holding periods. I do plan to make some changes to the AGG systems for my personal use (I made some already at the beginning of this year, e.g switched from SMA to absolute momentum) but will keep the original rules for the public portfolios. I’ll post on the changes soon. For the AGG systems I’ll stick with the same lookback period for all assets. Turns out the timing component for the AGG systems is almost irrelevant anyway. For the GTAA 13 system a different lookback period for each asset class could improve things but I don’t think its worth the added complexity. So, no I won’t make any changes to GTAA13.

Paul

Regarding abs momentum vs sma, Wes Gray at Alpha Architect sidesteps the issue in his robust asset allocation model by going 50% in when either abs mom or sma signal positive and 100% in if both do. His study shows improved risk adjusted performance.

M

Hey Scot, yep, that is what they do. It’s a big complicated but not a bad approach. Just based on the quality of the data, methodology, and periods used, I put a lot more weight on the paper I summarized in the post. My own results also agree with abs momentum being the better way to go.

Paul

Paul,

It sounds like Gary Antonacci agrees with your view regarding Wes Gray’s Robust Asset Allocation (by going 50% in when either the abs mom or sma signals positive and 100% in if both do). Overall Antonacci gave the book a good review. He also gave some detailed commentary on all the chapters.

Gary Antonacci’s review is on his website for the book by Wes Gray, Jack Vogle, and David Foulke’s entitled- “DIY Financial Advisor: A Simple Solution to Build and Protect Your Wealth”.

http://www.dualmomentum.net/2015/09/book-review-diy-financial-advisor.html

I have not read the new book but will try to pick it up. Have you read the new book? Any thoughts?

Lastly, Wes Gray wrote the forward of Antonacci’s book “Dual Momentum Investing”. I really appreciate how these guys give their honest opinions on investing subjects. And, I appreciate that you do too on this blog. Thanks.