TERADIME MONTHLY NEWSLETTER   -   MAY 2004

Topic: Market Timing - does it really work?

There are many books written about market timing and how to pick "the right stocks", mutual funds, etc.  You will often see the following statistics:

1.    "... from 253 market timing financial newsletters only 3 are still around after 10 years!"

Or here is my favorite one:

2.   " If you have missed the 3 best days of the last 5 years your average annual return on S&P 500 would fall from 11.5% to 3.3%!"

I've always found Statistics to be an interesting subject, though I personally believe it is what you do not say that is truly important.  Let's take a look at the above two examples of investing statistics.  What are the chances of any business to survive and prosper over 10 years?  Statistically, the chances are less than 1%.  So, did these market timing newsletters fail because they could not time the market or was it because they could not market themselves and generate enough income to stay in business? No one knows. Look at TeraDime's newsletter: you are getting it for free now and will be in the future; however, the market timing segment will become part of a subscription fee-only service in the very near future.  If TeraDime does not get enough subscribers, the website may be closed and TeraDime will be out of business. Does this mean that we cannot time the market, or does it mean that we could not generate a significant subscription base to make it a viable business?  No one will ever know.

The second, classic investment statistic could be rephrased as the question: What would be the return of your market timing portfolio if you only missed the 3 best days?  I'd like to add to that question 2 additional items that will help us uncover the information not being said:

a.      What would be the return of market timing portfolio if you not only missed the 3 best days, but you also missed the 3 worst days?

b.      What would be the return of your market timing portfolio if you missed the 3 worst days and you hit the 3 best days?

None of the investment management firms (Fidelity, Schwab, Merrill, etc�) will give you statistics behind these questions, because it is not in their best interest.  Investment management firms only make money if you buy and hold their actively managed mutual funds. They make no money if you trade once or twice a year and use ETF(s) (electronically traded funds) to manage asset allocation of your portfolio. To prove my point review the tables below, where the S&P 500 Index was rung through the above 3 questions:

S&P 500 BEST AND WORST DAYS
April 1984 to May 2000

MISSING THE BEST AND WORST DAYS OF THE S&P 500
April 1984 to May 2000

As you can see, if you had missed the 10 worst down days, you would be better off then missing the 10 best days.  Since your chances of missing best and worst days are the same, I like to concentrate on the last and second to last columns of the table above.  It should be clear from the table that by missing both the worst and best days you would do much better than hitting only the best days.  The reason is that most of the best days occur right after the worst days (dead cat bounce) and the �downs' outweigh the �ups'. 

Take the time period from October 16^th through 21^st, 1987.  The loss of 25.63% was followed by a gain of 14.43%; missing the loss would help your portfolio much more than making the gain.  "Dead Cat Bounce" is the common term traders use to describe an event when the market goes up sharply after a sharp sell-off.  Ever heard the saying, "Even a dead cat will bounce if dropped from the 20^th floor"?  There's another saying that has to do with cats having a better chance of survival if dropped from a high enough place due to always landing right side up, but that doesn't tie into this discussion.

Here is a formal definition of a Dead Cat Bounce:

A temporary recovery from a prolonged decline or bear market, after which the market continues to fall.

Now let me go into a more detailed analysis of the above 10 worst down days and see how a hypothetical, simple market timing system based on the 50 Day Moving Average (MA) would handle these days.

The idea is that you sell the S&P 500 index when it crosses the 50 Day MA on the way down and buy it back when it crosses it on the way up.  I also compare it to a hypothetical performance of the TeraDime trading system.  The TeraDime system incorporates the 50 Day MA in addition to other trading methodologies.

As you can see, even with a Simple 50 Day MA trading system, you would dramatically cut your losses.  And if I ever learned anything about investing, it is not how much you make, but how much you do not lose.

During the research for this newsletter I had to go back and check each and every date to see what would happen if I was investing with the Simple 50 Day MA system and, separately, with the TeraDime system.  Throughout, I reviewed countless graphical data.  The three graphs below particularly caught my attention: 

S&P 500 Index (yellow line - 50 day MA, blue - 10 day MA, and red - 200 day MA)

2/3/2004 - 5/3/2004 (now)

S&P 500 Index

7/14/87 - 10/13/87 (immediately before the 1987 crash)

S&P 500 Index

7/14/87 - 10/19/87 (3 trading later, in 1987; note the sell-off)

Do not get me wrong, here.  I have no idea where the market is going 3 days from now, nor do I even know where it is going to be tomorrow.  But don't you think it is quite interesting to note the similarities between the first two graphs?