Courtesy of Jean-Luc Saillard.
Yesterday I published a post on timing the market that was based on a monthly bar crossing below a 10 period moving average. To be totally accurate, the author mentioned that she uses a 10 period average for the crossover, but also says that other periods such as 6, 8 or more than 10 might work depending on the market. It also seems that even numbers work better than odd numbers of periods! Something to backtest another time I guess.
This time I will expand on methods outlined by Charles D. Kirkpatrick II in his book (Invest by Knowing What Stock to Buy and What Stock to Sell) and also his web site as well as outline a new method based on his findings. I spoke about this author and this book in a previous post where I mentioned his fundamental analysis method. I will not go over his stock picking process, but what I found interesting was his market timing methods – he outlines 2 of them – one simple one and the other more complex. Given his success I thought that something could be learned from him. For reference, here is an equity curve of his current portfolio:
The lime green line is the results of his picks and they don’t do too badly against the broader market. But the purple line is the result of his timing rules being applied to the stock picking screen. As you can tell by the flat line, for a big portion of 2008 and 2009, he was out of the market. He did miss the mid-year rally in 2008, but was out during the crash and suffered little drawdown compared to the market. Obviously the method is not perfect as 2010 was not great, but it could also be the results of bad picks!
But back to his market timing methods:
1. As explained in a PDF linked on his web site (Portfolio Construction using Kirkpatrick Methods), sometimes the simplest is the best. He uses 2 weekly moving averages and watches for crossovers. When the 2-week SMA of the S&P500 crosses below the 14-week SMA of the same index, he goes to cash. When the 2-week average crosses above the 14-week average, he goes back in using his stock screener. For example, lets looks at these averages over the last 2 years:
Weekly chart of SPY – Click to enlarge
The red circle point out where he would have gone to cash while the green ones point to weeks where he went back to the market. Keep in mind that these are weekly candles so while there is some whipsaw, this method does keep you in the market during good rallies and keep you out during corrections! For example, this method would have kept you out of the August and September corrections this year. Once again, you might miss tops and bottoms but it does beat buying high and selling low!
2. The method that he explains in his book is a little more complicated and deals with scaling in and out. His portfolios are based on models – mostly picking stocks with low price-to-sales ratio and of high relative strength. He tracks the model value on a weekly basis and checks it against moving averages – 12-, 26- and 52-week averages. If the value of the model crosses below the 12-week average, he sells 25% of the portfolio. If the value declines below the 26-week average, he raises 25% more cash and liquidates everything once the value declines below the 52-week average. This protects him from complete wipeouts! He proceeds the opposite way to return to market – investing 25% once the value crosses over the 12-week average, another 25% when above the 26-week average and is fully invested once above the 52-week average.
Since not everybody will track a specific model, this might be harder to implement. But in effect, we all access to a pre-made model. It’s called an index or in some cases, an ETF! I am not certain that Charles Kirkpatrick would approve of this, but based on the chart below it seems that it could provide the basis of a new method.
Weekly chart of SPY – Click to enlarge
In this case, the method would call for going to 25% cash when the index crosses one of the SMA lines, to 50% cash when it crosses 2 of the SMA and all in cash once below all 3 SMA. And reverse the process for going back to market, scaling back in each time the index crosses an SMA line 25%, then another 25% up to 100% in when all SMA lines have been crossed. This method would have kept you out of the worse corrections and got you back in quickly once the corrections were over, but in a cautious manner. There is some whipsaw at the tops and bottoms (and remember, this is a weekly chart going back 8 years), but in general, you are in during good rallies and out during corrections (or short)!
Now all you need is to pick winners!
