Evaluating a Complete Cycle

Jeff sent this post in from the road.
~Renae

Market timing can help investor returns.  The method used should reflect the investor's time frame, trading costs, and risk tolerance.

For investors with a long time horizon, we use market valuation models like the Fed Model to help us with asset allocation.  For more agile traders, we use more aggressive market timing.

Whatever the time frame, an interesting place to stop and take stock is the  completion of an investment cycle.  We like to start with a point where we completely got out of the market.  We then consider every trade until the next time we have sold all long positions.

This is a complete cycle.

The August - November Cycle: An Illustration

As we have done for the last several months, we give readers a glimpse of our approach.  We have been reporting each Thursday on trades made during the prior week, and also sharing the sector model ratings from the prior day.

The cycle began when we completely exited the market on August 8th.  We started buying on August 17th - nibbling really - with a biotech position.  As more sectors earned "buy" ratings we added positions, getting to 50% invested by September 4th and fully invested on the next day!

During this time we traded in and out of seventeen different positions.  This is important to note.  The system is geared to holding eight positions, each representing 12.5% of the portfolio.  In many cases where we remained fully invested a stronger position replaced a weaker one.  This is a good indication that the sector rotation method was working as we expect.

The other way to exit is when everything is becoming weak.  On November 14th  we had our first sale with no replacement.  By the next day, there were so few positions with a "buy" rating that we were down to 50% invested.  On November 20th we sold our last positions.

Overall Evaluation

The complete cycle evaluation helps the manager look at overall effectiveness and also sources of problems.  This cycle worked out quite well.  Our seventeen trades ranged from a gain of 26% to a loss of 5.3%.  The average gain was 4%.  Overall, we gained 8.5% on the portfolio in 105 days.  This is an annualized rate of 31.7%.

We benchmark against the S&P 500, which actually declined by almost 4% during the same period, an annualized loss of about 15%.

One cycle does not provide as much evidence as extensive testing, but we always like to compare real-time tests with our careful back-testing.

Comments

[Mike C]

Just my opinion, but with the recent moves in the stock and bond markets, I would think now is a particularly opportune time to revisit the valuation question in terms of what to do now.

The 10-year closed at 3.8% while the S&P 500 is trading at 15x forward estimates which is a forward earnings yield of 6.7%. I don't know the range of the historical spread off the top of my head, but I gotta think that's up there at the high end of the range.

Let's put aside the question/issue of individual sector/stock-picking where there are always opportunities and just look at the question of buying the S&P 500 versus buying the 10-year note versus holding cash or at least some percentage in cash.

According to the Fed Model metric, I would assume that stocks in aggregate as measured by the S&P 500 are a screaming no-brainer buy right now, and that one should be selling bonds, taking cash to 0%, and going 100% in an S&P 500 index fund right now based on that valuation measure. Please correct me if I am incorrect on that point.

With the S&P 500 down roughly 10% off the peak, and a divergence of opinions out there, both bullish and bearish, I would think now is one of those times when having a clearly stated, on the record view is important.