Jul 12, 2008: An intermediate term market timing model

  • The state of the markets
  • Active vs Passive
  • An intermediate term market timing model
  • Looking back at our pair trading strategy

  • Introduction

    It is often stated that no one rings a bell during market bottoms.

    For many years, I believed in this maxim, and stuck to the buy and hold approach. Now, 2.5 years since I started looking at the data, and documenting my thoughts during this ongoing experiment, I've changed my mind.

    Please don't get me wrong: I don't think that anyone can consistently pick exact intermediate bottoms and tops. What I do believe, is that one can do better than the venerable "buy-and-hold the index" strategy, by being more right than wrong on the direction of the markets.

    And this is what I set out to do some months ago as anyone following my writings since November 2007, has probably noticed.

    I looked at a few investors who are really good while being active. I watched what they do, and learned from their moves. I then applied my machine-learning skills to pick a large number of good features and build a intermediate-term timing model for the markets.

    So I now have a little bell that, I hope, would guide me in the future and will allow me to get defensive near/around intermediate market tops and get aggressive near bottoms. I don't expect my bell to be even close to perfect. In fact, as a machine learning practitioner, I know what is the expected error rate of the model. I also know that the real-time error rate may be bigger than the one I obtained during cross-validation.

    My hope is simple: that my little bell would be able to give me enough (rough) guidance to both outperform a passive strategy, and to assume less risk while doing so.

    Note that I said "hope". There's only one way to build confidence in my little bell model: to test it in real time. This real time period started two weeks ago and is already showing some initial promise.

    Two weeks are a too short period to draw any definitive conclusions. Only the future will tell exactly how accurate and reliable this model is.

    The state of the markets

    While I was on vacation the markets retested and broke through their March lows. We now have 3 major down legs in a bona-fide bear market. A few notable points:

    Active vs Passive

    Can active beat passive? Is there an optimal level for being active?

    Ample empirical evidence suggests that being active (and good enough) pays. Let me share two data points with you.

    Marketocracy.com has several tens of thousands of registered users. I looked at many of the top performers who have enough history to convince me that their success isn't a result of chance. What striked me is how high their turnover is. Almost all of the top performers' turnover is in the many hundreds of percent/year range.

    Essentially, these investors know when to lighten-up a position and when to load-up. They are typically intermediate-term contrarians. They think in weeks, not in years.

    One of the best players, a German guy going by the screen name "greenab", has an annualized return of 41.5% in the past 3 years or so. His turnover is over 1022% in the past 12 months. This means he's been turning his whole portfolio at a rate of once every 5 weeks or so. Here are a few screenshots documenting greenab's performance.

    Another master whom I've been watching for a while is Henry To of marketthoughts.com. Henry has a timing model which he applies to the Dow Jones Industrials (DJI). Near and dear to my own investing philosophy, he looks at a large and diverse set of features: fundamental, technical, liquidity, and sentiment in an impressive intellectual depth. He documents his thoughts on his site. His real-time record speaks for itself. Henry To's most recent 9 signals are shown in the following (S&P500) chart:

    Henry was a bit early getting 100% long in this down leg, but as you can see, you don't need to be a perfect timer in order to outperform the markets and assume less risk. You do need to be good at integrating facts, be a data-driven contrarian, and have great conviction in your moves, though.

    And clearly, you also need to turn your portfolio over frequently enough to take advantage of the extreme ups and downs of the market.

    Take any upward sloping stock chart, imagine it is a string and stretch it in its general upward direction. Obviously it would reach much higher this way. This is self-evident, and is exactly what intermediate market timers are good at doing.

    My intermediate term market timing model

    Without going into the painful details, here's a brief description of my intermediate-term timing model.

    Looking back to our pair trading strategy

    A bit over a month ago, I suggested a strategy for uncertain and even bearish times. A pair-trade going long mid-cap with emphasis on growth, while simultaneously going short large-cap with emphasis on value. A quote:

    Even if this trade does not work as expected, I believe this pair-trade should lose less than the broad market, assuming the markets revisit their March lows. In other words, this is a market neutral trade, with some downside protection. In addition, I feel it has a higher upside potential than sitting on cash in times of increasing uncertainly, rising inflation, and schizophrenia.

    The strategy has performed as I expected it to perform. It didn't gain much, unless you picked the best pair combo (IJK vs IWD), but it completely avoided the nearly 10% melt-down in the broad markets. Here's a chart showing the relative performance of some of the ETFs mentioned:

    If on Monday (July 14th) the markets rally, and financials rally even more (a relief rally) it may erase and even reverse these gains. Still, I think this strategy is viable for the next few months as a low-risk bet for those who fear the market has still a way to go down.

    Then again, my own bottom bell has just given the signal, so I would at least partly cover the short part of the pair for now.

    Disclaimer: this should not be considered as investment advice. It is merely describing my own thoughts and actions.

    As always, any feedback, question, request, criticism, is welcome.

    -- ariel