By Jack Forehand, CFA (@practicalquant) —

There are few topics that are more controversial in the stock market than market timing. Most long-term investors will tell you that market timing is impossible. Given that in order to time the market, you not only need to know when to get out, but also when to get back in, you can see why they think that. And on top of that, many market declines are just corrections and not bear markets, and telling the difference between the two is next to impossible in advance.

Burton Malkiel, author of “A Random Walk on Wall Street” summarized this point better than I can in an article for Wealthfront.

Without doubt, the most serious mistake individual investors make is trying to time the market. Neither individual nor professional investors are able to make consistently accurate calls on the direction of market prices. In fact, I have never known anyone who knows anyone who has consistently made accurate directional bets on either equity or bond prices.

Warren Buffett agrees.

“People that think they can predict the short-term movement of the stock market — or listen to other people who talk about (timing the market) — they are making a big mistake,”

So it seems like an open and shut case, right? Investors should just buy and hold and stay the course through the inevitable declines in pursuit of their long-term goals.

But the problem is it isn’t that simple.

While I wouldn’t disagree with anything in the above two quotes, in the real world all investors have to deal with a factor that complicates the process. That factor is their own emotions.

Emotional reactions are a particular problem during bear markets. Below is a chart of the 25 worst declines since 1928 sourced from Yardeni Research.

So if you assume investors will stay the course during market declines like these, then buy and hold is a great approach and is likely to produce the best returns. But most investors don’t do that, so in the practical world, implementing disciplined systems to limit losses during market downturns can enhance investor’s returns, even if they produce similar actual returns to a buy and hold approach.

A Practical Look At Market Timing

Talking about implementing an approach to limit market losses is easy in theory. Doing it in practice is much more difficult.

So how can it be done?  Before we talk about that, let’s first look at how it can’t.

The obvious place investors want to start when they look for a strategy to move in and out of the market is valuations. After all, if the market is expensive it makes intuitive sense to sell, and if it is cheap, it makes sense to buy. Although that approach sounds great in theory, it suffers from a major problem – it doesn’t work. The reason is that the market can stay in undervalued and overvalued states for very long periods of time. The current period we are in is a great example of that. The market is trading at extremely high valuations right now, but the same was true two years ago. Investors using valuations to time the market would have missed significant gains in the past few years.

The situation was even worse for that type of approach in the late 90s. Current valuations look downright cheap compared to the valuations in that period. For example, the current market valuation, despite how high it looks in a historical context, equates to the valuation from mid-1997. And the market proceeded to produce 20%+ annual gains for the next two and half years after that. Anyone trying to time the market based on valuation lost a lot of money while that bull market continued to run. Of course, they ended up being right eventually, but not until after they had lost years worth of significant gains.

Using the previous performance of the market to determine entry and exit points is just as bad as using valuation. The fact that the market was up or down the previous year has zero impact on whether it will be up or down the next year.

Ben Carlson of Ritholtz Wealth Management posted a chart on Twitter this week that illustrates this point perfectly. The chart show that the odds of the market going up or down in any given year are essentially the same regardless of what happened the year before.

Examining Trend Following

So if you can’t use fundamentals and you can’t use previous market performance to time the market, then what can you use?

The answer is a system called trend following.

Although there are many approaches to trend following, the concept behind it is very simple – when the market is in an uptrend you stay invested, and when that uptrend is broken you move into bonds or cash until the uptrend re-establishes itself. In practice, it is most often done using moving averages, which are just the average price of the market over a specified period of time. For example, the 200 day moving average is the average close price of the market over the past 200 trading days. Moving averages have the advantage of moving slowly over time since they are the average of many numbers (200 in this case) vs. the daily price, which is just one number. So moving averages help to show the overall trend of the market.

The simplest moving average strategy just looks at the price of the market at regular intervals and compares it to the 200 day moving average. If the market is above that price, you continue to hold stocks. If it falls below the moving average, you move into cash or bonds.

In their white paper “A Quantitative Approach to Tactical Asset Allocation” (link to download), Cambria Investments takes a look at this simple 200 day moving average strategy vs. the buy and hold return of the S&P 500. What they found is that the strategy produced a slightly better annual return to buy and hold, but did it with less volatility and lower drawdowns.

Figure 7: S&P 500 Total Returns vs. Timing Total Returns

	S&P 500	Timing
Returns	9.32%	10.18%
Volatility	17.87%	11.97%
Sharpe	0.32	0.55
Max DD	-83.46	-50.29
% Positive	61.58%	75.80%
$100 Becomes	$2,163,361	$5,205,587
Inflation CAGR	3.11%	3.11%

The less risk part of the equation is what is important here because volatility and drawdowns are what lead investors to make poor decisions and buy and sell at the wrong times. So the difference in returns above would very likely be much greater when investor behavior is factored in, and the reduced volatility and smaller losses would make the trend following portfolio easier to stick with.

Easier to stick with doesn’t mean easy, though, and like all systems, trend following has its drawbacks. The primary one is that it can get faked out in back and forth markets.  Although many trend following systems got the 2008 bear market right and suffered minimal losses, they have had a much harder time since then. This is because every market decline since 2008 has been a buying opportunity rather than a bear market. The trend following model got faked out several times between 2008 and now and sold, only to see the market go back up. It was then forced to buy back in at higher prices. Those fake outs were more than offset by the loss that was avoided in 2008, but they still tested investors’ patience nonetheless. In the market timing systems we have tested, we have found that even the best trend following systems are wrong more than that are right. The reason they work is that when they are wrong, the performance loss relative to the market tend to be minimal, but when they are right (typically during bear markets), the losses saved can be very large.

A Tool That Can Work For Many Investors

No investing strategy is perfect and every approach has its positives and negatives. Trend following is no different. Even though trying to time the market is most often a losing battle, an approach like this can add value for many investors because it can help to avoid some of the biggest behavioral mistakes. For investors who can stay the course during the markets ups and downs, buy and hold remains a great approach, and probably the best one for the long-term. But for the majority of investors who can’t do that, trend following is an approach worth considering. Just don’t tell Warren Buffett I said it.

Photo: Copyright: gopixa / 123RF Stock Photo

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Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.