We have seen that a simple timing system can add substantial value to U.S. stocks over the long term, and to a long-term market bubble and collapse, using the Nikkei as our proxy.
- The Nasdaq tech bubble and subsequent crash
- The Nikkei property bubble and subsequent crash
- The ‘Roaring 20s’ stock market bubble and subsequent Great Depression
This is an especially interesting study because it provides for no ‘escape valve’ to earn returns while these markets are thrashing their way through their respective “Grizzly Bear” markets. The best a system can do is rest in cash while the markets churn. For this reason, this study is also an excellent ‘stress-test’ of timing and rotational systems, as it is difficult to conceive of any period where markets have provided a more intense challenge for investors.
The period from early 2000 through late 2002 saw U.S. markets peak following one of the richest parabolic runs in market history: the tech bubble. The collapse that followed in the Nasdaq stock market lasted almost 2 years, and took the index down 75% from its highest monthly close in April 2000. After bottoming in 2002, the market gained over 100% through late 2007 before experiencing a second collapse in 2008 which cut the value of the index in half. The market then experienced a very steep rally, which we are still enjoying today.
Chart 1. Nasdaq Composite 1998 – 2010
Source: Wikiposit.com, Butler|Philbrick & Associates
The Nasdaq peak and collapse looks similar to the parabolic peak and collapse in the Japanese stock market which occurred in the late 1980s and throughout the 1990s. Chart 2. below closely aligns the Nikkei’s final surge from 1988 through 1990, and its subsequent collapse through the year 2000, with the Nasdaq’s peak and collapse. Note how closely the trajectory of the Nasdaq tracked the Nikkei’s waterfall – the price series are not exactly the same, but they certainly ‘rhyme’.
Note that the Nikkei return series was transformed to match dates with the Nasdaq series above, so the dates on Charts 2. and 3. are not accurate for these markets.
Chart 2. Nikkei Japanese stock market composite 1988 – 2000
You can see that diversification works – sort of. While the combined portfolio didn’t gain in value over the period, neither did it lose any, with annualized returns of 0.06% per year. The portfolio did gain almost 60% in the first couple of years, and then lost over 50% from its peak value (see Max Total Equity DD in Chart 4.), but it ended up right back where it started by the end. This is much better than it would have done by holding the Depression market or the Nikkei alone.
Market Timing and Rotation
As with our other studies, we will apply three simple strategies to this basket of 3 investments which have the potential to substantially improve returns, and with much less risk of loss.
Moving Average Timing System
The first approach involves a simple moving average timing system. In this case, we own an equal amount of each index, rebalanced annually. However, if any of the 3 indices closes any month below its 10-month moving average, the system will sell that index and hold cash instead (at the U.S. dollar rates prevailing during the Nasdaq’s run and collapse around the turn of the century). When an index closes back above its 10-month moving average, the system will re-purchase the index at the then prevailing price.
A simple moving average system improves risk-adjusted performance dramatically. With this system, we are able to achieve substantial positive returns over the period of 5.4% per year, which compares with returns of ~0% per year for the ‘Buy and Hold’ example. At the same time, risk is reduced by 50%, with the worst total peak-to-trough loss over the period of just 24%, versus 56% for the ‘Buy and Hold’ approach.
Chart 5. 3 Grizzlies with 10-Month Moving Average Timing System
Amazingly, while the 3 Grizzlies are raging and tearing a big hole in most investors’ portfolios, Goldilocks is able to coax the 3 bears into delivering returns of almost 13% per year! The risk in the system is only slightly higher than the risk to the rotational system with cash, with a maximum peak-to-trough loss of 24% versus 20%, and an investor is never below water on his investments for much longer than 2 years.
We endeavored to test some simple timing systems under very extreme conditions to see how they held up. It is important to test how systems behave under a variety of market conditions so that we can be as certain as possible that our systems will work no matter what the market holds in the future.
We chose the three most volatile, deepest bear markets of the past 140 years for our test case. While we can’t be certain that these markets represent the most challenging conditions possible under which our systems might be forced to operate, we can say that these are some of the most challenging conditions investors have faced in history. While future markets will throw new and unexpected challenges at us, studies like this help to demonstrate how simple systems can adapt to almost any market environment to deliver more consistent and robust returns than ‘Buy and Hold’, and with substantially less risk.