btdcom.jpg (16753 bytes)FEATURED ARTICLE                                                   

  June 2006

Using Market Timing Signals

                       "There is a time to plant and a time to reap" .... Ecclesiastes.

"There is a time to be aggressively invested and a time to await the time to be aggressively invested" .... BeatTheDow

The companion Feature Article "Can You Afford Not to Time the Market?" emphasizes the importance of risk management to your financial well-being, especially if you are nearing retirement or have a large nest egg to protect. We know of no better way to control risk than to respect market timing signals. By respecting market timing signals we don't mean blindly following a single signal, but rather heeding the status of a handful of different signals.

Other approaches to risk management, such as applying percentage stop-loss rules, or using trailing stop-loss prices, are effective for managing individual stock holdings but are of limited value for managing mutual fund holdings. (Stocks may be sold based on "stop-loss orders" but mutual funds may not.) The use of market timing signals offers a scientific approach to risk management because the results are reproducible, easily measured and applicable to funds and large groups of stocks, such as those comprising the S & P 500 Stock Index or Russell 2000 Stock Index.

For purposes of this article, we selected three ProFund index funds, three timing signals, and a timeframe confined to the current four-year cycle (see the Featured Article entitled "The Four Year Cycle"). Our purpose was to illustrate the significant recent gains achievable from using timing signals to trade index funds (either in bull fund vs. money market fund combinations, or in bull fund/bear fund pairings). Because the timing signals employed derive from Russell 2000 Stock Index (R2K) performance, we selected a one beta R2K index fund (SLPIX), a two beta R2K index fund (UAPIX), and a minus one beta R2K index fund (SHPIX). The minus two beta R2K index fund (UCPIX) did not exist at the begining of our chosen timeframe, so we omitted it from our analysis.

For benchmark purposes, the table below shows the performance of the three funds, plus a money market fund, on a buy-and-hold basis (i.e., without timing). All the numbers in the table represent the value to which $100 invested on June 30, 2002, would have grown (or shrunk) by June 20, 2006, as a result of employing the various trading strategies.

                          

                                Value of $100 @ End of Period, From

                  Timing Index Funds, July 2002 through June 2006

Timing Signal -->

B&H

T S #1

T S #2

T S #3
ProFunds Fund or Pair

 

 

Ultra Small Cap (UAPIX), 2x Russell 2K Index

170

Small Cap (SLPIX), 1x Russell 2K Index

144

Short Small Cap (SHPIX), -1x Russell 2K Index

60

 

Money Market Fund (MM)

108

Timed Pair: UAPIX/MM

317

396

477

Timed Pair: SLPIX/MM

189

 213 232
Timed pair: UAPIX/SHPIX

369

 524 685

Timed pair: SLPIX/SHPIX

221

281

333

The first timing signal (T S #1) is a simple signal based on the crossover of two moving averages. T S #2 is the Domestic Stock Market timing signal employed at Beat The Dow; T S #3 is a proprietary signal distributed by a nationally known timing service. T S #3 of a well-known  .8% per year but would have significantly reduced maximum drawdown to 13.1%. Applying this strategy, it would have been necessary to switch between the Nasdaq and the money market, or vice-versa, about 3.6 times per year, or once every 3.3 months. One would have been invested in the Nasdaq 74% of the ten-year period and in the money market the remaining 26% of the time.

The USMI and T117 signals were developed by Dr. Dennis Meyers and are described in detail in the August 1995 and November 1997 issues, respectively, of Technical Analysis of Stocks and Commodities magazine. The USMI signal uses weekly data, was invested 85% of the time between 1990-99, and rarely switches. Although there have been only 6 buy signals and 6 sell signals since 1980, the USMI signal avoided the Crash of '87, the Gulf Oil Crisis of 1990 and almost all of the bear market of 1994. The T117 signal uses daily data, switches much more frequently, and delivers about the same returns as the USMI signal, but with much less drawdown.

The R2KS&M signal is a combination of two signals based on the Russell 2000 Stock Index. One signal derives from a stochastics histogram of the Russell 2000, the other from a MACD (moving average convergence /divergence) histogram of the Russell 2000. The R2KS&M signal buys when both component signals are on a buy and sells when both are on a sell. Invested only 57% of the time between 1990-99, this signal improved returns over buy-and-hold by about 15% while reducing draw down almost 70%. Because of its superior risk-control record, we use the R2KS&M signal as the Primary Domestic Stock Market Timing Signal at BeatTheDow.  NOTE: The RutVol signal used after 2002 is a variant of R2KS&M which takes volume into account.

The LandSCap signal yielded the highest returns for the ten-year period.  It is a combination of signals separately addressing large cap and small cap stocks. LandSCap buys when both component signals are buys, but sells when either signal reverts to sell status. Its use would have improved Nasdaq returns for 1990-99 by 33% while reducing maximum draw down over 40%.

In summary, all five timing signals shown in the table above improved on the buy-and-hold returns of the Nasdaq Composite Index and all five reduced the risk, some quite dramatically. Following the most sensitive signals (R2KS&M and LandSCap) would have required one to switch from the index to the money market, or vice-versa, about once every three months. Following the least sensitive USMI signal would have required a switch slightly more frequently than once every two years. An investor's assets would have been exposed to market risk from 57% of the time, following the R2KS&M signal, to 85% of the time, following the USMI Signal.

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