Market Timing Strategy (Backtest And Example)
It is a common belief in the investment world that a market timing strategy does not work. And as such, there is no point in trying to predict the best time to buy or sell a stock to get the best returns. Whether the assertion is true or not is up for debate, but one thing that is certain is that earning big profits by correctly timing buy and sell orders just before prices go up and down is far from easy. However, if you wish to practice market timing, you will need a market timing strategy.
Market timing strategy refers to an investing approach whereby an investor makes buying or selling decisions by predicting when and how a financial asset will move in the future. By timing the market, the investor aims to outperform the market by taking a long position (buying) at market bottoms and a short position (selling) at market tops.
In this post, we take a look at the market timing strategy. We end the article with a backtest to show if market timing works or not.
What is market timing (definition)?
By timing the market, the investor aims to outperform the market by taking a long position (buying) at market bottoms and a short position (selling) at market tops. Market timing strategies can stem from any number of ideas or assessments, such as studying a historical price chart and attempting to learn patterns. This investment approach can be applied to any security. While stocks are the most common example, some investors use market timing to guide their bond, gold, or real estate investments — in fact, anything that’s subject to market forces could be traded with market timing.
Timing the market is frequently a crucial component of actively managed investment strategies, and it is virtually always a fundamental trading technique. Fundamental, technical, quantitative, or economic data can all be used to guide market timing choices. While many investors, scholars, and financial experts feel that market timing is impossible, some investors, particularly aggressive traders, have a strong belief in market timing. It is debatable whether good market timing is feasible, but practically all market experts believe that doing so for any significant amount of time is a challenging undertaking.
Does market timing work?
Market timing is often seen as a high-risk approach. Correctly timing the market may result in a large reward, but the chance of recurrent success with market timing is substantially smaller than with many other wealth-building tactics.
Some simple market timing backtesting by Quantified Strategies using S&P 500 Index data from 1960 to 2021 shows that you increase the risk of getting mediocre returns with market timing if you get it wrong. “Removing just a few of the best and worst days in the price series changes the end result dramatically.” They concluded that in general, market timing is a pointless exercise if you are a long-term buy-and-hold investor.
But why does wrong market timing influence the returns on investment so much? The answer can be found in the power of compounding. Surely, compounding (Warren Buffett calls it Snowballing) can shout up your returns if you get it right, but if you get it wrong, your mediocre returns or even losses get compounded as well, giving rise to a poor result in the end.
The best advice for long-term stock investment is probably to invest in stocks and forget about it — aka buy and hold. Since you have no control over the sequence of returns, it’s best to control what you can control — your own behavior. There is a reason women are better investors than men when it comes to investing — they simply invest and forget about it without trying to beat the market. Women are known to beat the majority of those who do market timing.
Why is market timing so hard?
It is very difficult to time the market because market action is random. The people that make up the market act according to their beliefs and strategies and on their own timing without any unifying force, so the net effect of their actions is pretty much random. While market participants are often inspired to trade by some form of news or analysis, whether it be economic data, stock research, or their own intuition or preference, whatever information they get is most likely already reflected in pricing by the time they can react to it.
In today’s tech-driven world, capital markets have gotten quite effective at pricing in all available information, making it impossible to second guess mark values even for specialists. To make matters worse, in order to properly time the market, investors must make the decision to purchase or sell equities not once, but twice. Nobel laureate Professor Robert Merton put it succinctly in a recent interview:
“Timing markets is the dream of everybody. Suppose I could verify that I’m a ‘70% hitter’ in calling market returns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.”
In fact, even professional investors have difficulties outperforming the market. Standard & Poor’s research found that over the last 10 years to December 2018, 83% of Australian equity funds, 91% of international equity funds, and 71% of Australian fixed-income funds failed to beat their benchmarks after costs.
What is the biggest risk of market timing?
The biggest risk of market timing is getting it wrong and missing out on the best market moves. That is, you are not invested when the market is making huge gains because you probably exited from your earlier positions. Worse still, when you get it wrong, you may not only miss out on the best market moves but may also take the hit of the worst market days. Such scenarios can mess up your overall returns.
As Quantified strategies showed in this article, the CAGR of a fund invested in the S&P 500 from 1960 to the end of October 2021 was 7.4% (no dividend reinvestment), but if you remove the best 10 days, it falls to 6%. If you remove the worst 10 days, the average annual return shoots up to 9.3%.
To avoid the risk of getting your timing wrong and missing the best moves and incurring the worst declines, it is better to practice buy and hold for long-term investments.
What is market timing theory?
Market timing theory is a different financial concept that is not related to retail investors timing the market when investing in stocks. It is one of many such corporate finance theories for corporations’ capital structure.
The market timing hypothesis is a theory of how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. However, the empirical evidence for this hypothesis is at best, mixed. A complete market timing theory ought to explain why at the same moment in time some firms issue debt while other firms issue equity, but that has not been the case.
On the aspect of individuals investing in stocks, market timing is based on the idea that with the right tools, information, and experience, one can guess with a high degree of accuracy when the market bottoms and when it tops. However, that is nearly impossible to achieve with consistency.
What are some market timing examples?
There are different ways investors practice market timing. These are the common ones:
- Sector rotation: This involves moving your capital from one market sector to another based on how you think they are performing. For example, if you think that the tech sector would perform best within a given period, you move your funds into the sector and when the momentum in the sector dies down, you sell and move your funds to the current hot sector.
- Market rotation: This switching among different countries’ securities. With this, you can move your funds to emerging economies if you think that they would outperform the US market over a given period.
- Asset rotation: This involves switching between assets. For example, you can switch from stocks to bonds and risk-free treasury bills if you think a stock market crash is underway. Some investors also switch between stocks and commodities, such as gold.
What is market timing fallacy?
Market timing means you would know when the market has topped and sell your position in the stock market as what would follow next would be a market crash. Then, you would wait on the sideline for that crash to happen and then buy back in at a much cheaper rate when the market has bottomed. This is the perfect description of “buy low sell high.”
But how do you know when to sell and when to buy back in? No strategy, tool, or individual can consistently predict how the market will move over a long time. Experience and research have shown that time and again. Believing that you have some magical powers to always know when to get out of the market and when to get back in (at the very top and bottom) is a market timing fallacy.
“Time in the market beats timing the market”
This is an old adage in the stock market. But of recent, the statement was made by Keith Banks, Vice Chairman of Bank of America, on CNBC’s “Squawk Box” in March 2020 when he said, “The reality is, it’s time in the market, not timing the market.”
The statement implies two things: the time to accumulate money and the time you spend studying the market to know the right stocks to pick. Trying to time the market is an effort in futility. It is always better to buy and hold for a long time. When practicing buy and hold, the earlier you start investing, the better. All things being equal, someone who started investing at 25 years of age would accumulate more money at retirement than someone who started to invest at 35 because the former has more time in the market than the latter.
What are some market timing indicators?
There are many of them, but we will focus on these common ones:
Volatility Index (VIX)
This is a measure of implied volatility in the US stock market. Created by Cboe, the index uses option activity in the S&P 500 to quantify investors’ desire to hedge their portfolios (usually to protect from downside risk). When investors are rushing to options to protect their portfolios, it means they are expecting market turbulence in the near future. On the other hand, when investors are not expecting a lot of turbulence in the market, the use of options declines. This is the principle the VIX is based on. As a result, a rise in the VIX suggests elevated levels of fear (which is why it was nicknamed “the fear index”).
When using VIX to time the market, high values indicate a potential market decline, while low values below 10 indicate calmness in the market.
Yield curve
A yield curve is a graphical representation of the relationship between the interest rate paid by an asset and the time to maturity. It plots yields (interest rates) of different bonds issued by the same institution (bond with the same credit quality) against their different maturity dates — the interest rate is plotted on the vertical axis, while time to maturity is plotted on the horizontal axis.
The most commonly followed yield curve compares U.S. Treasury notes with terms of three months, two years, five years, 10 years, and thirty years. Normally, the curve slopes upwards to the right, indicating that longer-term bonds offer more yields than shorter-term bonds or notes. This is an indication that equity investors are not running for safety.
When there is a yield curve inversion, the shorter-term bonds offer higher yields than the longer-term bonds, indicating that equity investors may be running to the bond market for safety — a sign of a stock market downturn.
What is the cost of market timing?
The cost of market timing can come in many ways, but the primary cost is from transaction fees, such as spreads, trading commissions, and so on. Another cost is the tax you pay on your profits. If your trades are closed within a year, you will be taxed based on the short-term capital gains rate, which is more than the long-term capital gain rates charged on investments that stay for more than one year.
Market timing strategy backtest
A strategy backtest with trading rules and settings is coming shortly.
FAQ:
What is market timing fallacy?
The market timing fallacy is the belief that one can consistently predict market tops and bottoms, allowing for perfect “buy low, sell high” execution. In reality, consistent and accurate market timing is nearly impossible to achieve.
What is the cost of market timing?
The cost of market timing includes transaction fees (spreads, trading commissions) and taxes on short-term capital gains for trades closed within a year. These costs can erode returns and impact the overall profitability of market timing strategies.
How do you backtest a market timing strategy?
Backtesting a market timing strategy involves creating specific trading rules, coding them, and testing against historical data. Backtesting results provide insights into the strategy’s performance, including trade frequency, gain per trade, and maximum drawdown.