Using Market Timing Signals with an Index

"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" .... Beat The Dow

The companion 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, that is, by heeding the status of a handful of different signals.

The simplest timing signals derive from crossovers of long and short moving averages of an index or equity's price. Let's look at the past 9 years and focus on the Russell 2000 Stock Index. (Timing signals associated with small cap indexes are more effective than signals associated with large cap indexes, probably because small cap equities respond more quickly to changes in investor confidence than do large cap equities.) The Russell's Compound Annual Gain (CAG) for 1998-2006 was 7% with a Maximum Draw Down (MDD) of 46%. Buying the index whenever its 10-day moving average crossed its 50-day moving average from below and selling it whenever the 10-day moving average crossed the 50-day average from above would have pumped the CAG up to 11% but, more significantly, lowered the MDD to 19%.

Click here to see a chart of the Russell 2000 for 1998 - 2006 with its price and moving averages in the upper portion and adjusted returns in the lower portion. The difference between the two lines in the lower portion of the chart represents the improved returns from remaining in money market funds when the Russell's short moving average is beneath its long moving average. The green part of the red-green line in the lower portion of the chart shows returns from periods invested in the money market.

More sophisticated timing signals deliver greater improvements in both CAG and MDD over buy and hold performance, but these timing signals tend to deteriorate over time. To illustrate both of these features, the table below shows the %CAG and %MDD for the Russell 2000 Stock Index for two different overlapping six-year periods, 1998-2003 and 2001-2006, and for the nine-year period as a whole, 1998-2006, when bought and held, when timed by its 10-day and 50-day moving average price crossovers, and when timed by three timing signals, each based in part on the Russell itself.

Although the timing signals didn't deliver as impressive returns in the last six years as they did during the more volatile period from 1998 to 2003, they incurred lower maximum draw downs and for the last nine years--in contrast to buy and hold performance--the three more sophisticated signals delivered three to four times the return while reducing maximum draw downs by two-thirds or more.

In summary, the empirical evidence in favor of using timing signals with market indexes is quite convincing.