If you want to invest successfully over the next decade, you have to implement a market timing strategy. This requires you to follow a series of market timing indicators.
Bear markets have the potential to crush investor returns and can shred thousands of dollars from your retirement portfolio in the process. Market volatility and risk have grown at an exponential rate since the 1950s and since the advent of the derivatives markets and is here to stay.
If you can't identify "near-market" inflection points, you're in for a roller-coaster ride – it's as simple as that. Trends break, economies shift structurally, and buy and hold is a suboptimal strategy. You need a market timing strategy if you plan to stay invested in the market and if you plan to maximize your returns.
Short-term (hourly, daily, weekly) market timing strategies are largely unreliable and ineffective. Finding the right balance between effectiveness, usability of a strategy and transaction costs makes stock market timing better suited for medium-term and long-term investing. Catching major bull markets, avoiding major bear markets and keeping transaction costs low is the name of the game for successful long-term market timing systems.
Average investors will have a difficult time succeeding at market timing if their trading time frame is too short. Even if such a strategy effectively identifies profitable entry/exits points, transaction costs, the time involved in tracking trades and taxes typically erode gains over the long term. Tax considerations must be carefully considered if implementing a timing strategy, and most market timing strategies should be implemented using Exchange Traded Funds (ETFs) from within a tax-deferred or tax-sheltered account.
Parallels are frequently drawn between market timing and speculating. In the short term, this might be true. But in regard to timing long-term trends, it couldn't be further from the truth. Timing long-term trends works! And you're going to relegate yourself to suboptimal returns if you don't embrace this.
Many mutual fund companies and advisers who support a "buy and hold" investing style are convinced that market timing does not work. For example, many investors approaching retirement experienced dramatic effects on their portfolios during the financial crisis and recession of 2008-2009, just at a time when they needed the funds most.
People are beginning to see that remaining invested in bear markets can actually increase volatility and risks. In addition, the psychological pain associated with watching a lifetime of savings decrease in value over a sustained period can take a damaging toll on confidence levels and one's own general outlook for the financial future.
Over the next few weeks, we're going to discuss nine market timing indicators, many of which can be built right here using GuruFocus' economic data service. They are some of the most effective and reliable signals of long-term trends.
Investors using these market timing signals would have seen the 2008-2009 bear market coming and could have reduced their equity positions before significant declines took hold in the general market. Market timers using these signals would have, time and time again, been able to see early warning signs and adjust their asset allocations accordingly. Investors following these signals would have also been well positioned to take advantage of the massive runup in stock prices starting in 2010.
The bottom line is that these market timing signals help notify investors when to get out of the market and when to get in the market in a defensive manner. While they might not identify exact inflection points, their value comes from reliably identifying "near-market" inflection points. That is, they identify turning points at an early enough stage to enhance your long-term performance results.
It is important to reiterate that we do not advocate market timing in individual stock positions. The indicators are best used to time the market through the use of exchange traded funds (ETFs) and, in particular, those that track the Standard & Poor's 500 and the S&P/TSX.
The first indicator is the "triple-crossover" moving average model.
Triple Crossover Moving Average Model – Overview
This model (or system) is designed to give a read on the total amount of short-term and long-term momentum in the stock market. It can help investors see changes in the market and take action early on the upside/downside. The key to this system is that it requires persistent and pervasive movements in stock prices and trend lines to signal inflection points in the market and is meant to filter out day-to-day noise and focus only on the signals.
Methodology
One of the easiest ways to gauge the long-term direction of the market is to compare the index with its 200-day moving average. If the index is above the 200-day moving average, then the market is most likely in an uptrend. Alternatively, if it is below the 200-day moving average, then it is most likely in a downtrend. Also, the distance between the index value and the moving average indicates how strong the trend is. The greater the spread between the index and the 200-day moving average, the stronger the trend. The market is most likely consolidating or oscillating if the spread remains tight and the index criss-crosses its moving average.
Some traders rely on only the 200-day moving average line to generate their trend signals. When the index value crosses the 200-day moving average from below, a buy signal is triggered. Alternatively when the index value crosses the 200-day moving average from above, a sell signal is triggered.
We like to employ a triple-crossover method. This means that, rather than relying on only the index value and the 200-day moving average to generate our trend signals, we rely on a combination of price moves between the index, a 50-day moving average price line and a 200-day moving average price line. To mitigate the impact of falls signals, we also employ a moving average oscillator (measured as the percentage difference between the 50-day and 200-day moving average lines). Based on this technique, an early buy signal is triggered when the index value crosses the 200-day moving average line from below.
A "first" confirmation signal is triggered when the 50-day moving average line crosses the 200-day moving average line from below, and a "second" confirmation signal is triggered when the spread between the 50-day moving average line and the 200-day moving average line grows to 5%. Alternatively, an early sell signal is triggered when the index crosses the 200-day moving average line from above, with "first" and "second" confirmation signals triggered when the 50-day moving average line crosses the 200-day moving average from above and when the spread grows to -5% respectively.
U.S. results and interpretation
Figure 1: S&P 500, 50-day MA, 200-day MA, oscillator
The results presented above are fully satisfactory. The system accurately predicted a strong buyers' market in the late 1990s, giving no false sell signals leading right up to the peak of the tech boom. The model gave a few early sell signals in late 1998 and 1999 but no confirmation signals until late 2000, at which time investors would have made some nice profits. It also identified a nice re-entry point in mid-2003 following a +5% spread of our confirmation oscillator.
Investors buying in 2003 and holding until the next strong sell signal in 2008 would have also earned exceptional returns. Once again the system provided an accurate and timely buy signal in mid-2009 following the market collapse in 2008, with a sell triggered in late 2011 and another buy in early 2012. The system recently triggered an early buy signal; however there have been no confirmation signals. For now, we appear to be in a consolidated or oscillating market. Investors are advised to continue to hold their positions.
Canadian results and interpretation
Figure 2: S&P 500, 50-day MA, 200-day MA, oscillator
The Canadian results are also fully satisfactory. The system accurately predicted a strong buyers' market in the mid- to late 1990s. The model gave a strong sell signal in mid-1998 but then retriggered a strong buy in mid-1999. This was followed by an early sell signal in late 2000 with rapid confirmation signals. Investors buying and selling as prescribed would have earned sizeable returns and avoided the full collapse of 2000.
It also beautfully timed a re-entry point in early 2003 following a +5% spread in our confirmation oscillator. Investors buying in 2003 and holding until the next strong sell signal in 2008 would have earned exceptional returns. Returns would have been even higher if investors acted on our first confirmation signal rather than waiting for our second (oscillator) confirmation signal. The system signaled a strong sell in September 2015 and, while an early buy signal has almost been triggered, still requires more momentum before highlighting a new entry point.
For now, and based on these model results, investors are advised to stay out of the Canadian market.
