Timing the Stock Market
Can the stock markets be timed? Most people agree that it cannot be timed in a consistent manner. And the occasional successful timing is usually attributed to luck than skill. Certainly, if no one can time the market perfectly on a consistent basis, then no one should attempt to do that. This is the part that I disagree.
First, we need to define what exactly it means to time the market. The best possible scenario is where we are able to exactly buy the bottom and then exactly sell the high. Again, most would agree that is not a practical expectation. Most would also agree that it is not practical to do so in every attempt. So, then what is practical?
What if we define the success in timing the market as
We want to buy “close to the low” and sell “close to the high”. (We could get very specific here and say we want to buy within 10% of the low and sell within 10% of the high. But let’s keep the discussion simple for now)
We want to achieve the above most of the times that we attempt to
Those criteria seem reasonable and more than likely will make us money. However, we still need to figure out a “system” so that we do not make buy and sell decisions from the gut. This is where trend following can help.
Trend following as a way to play the markets has been around for several decades. I will not go into details here. This is a good link to read up on it. Michael Covel has probably written the most number of books on it.
The basic principle revolves around analyzing price charts and observing patterns that indicate “probabilities” around what will happen next. Note that I specifically used the word probabilities instead of predictions. It is a big difference. When we say probabilities we mean a mathematical chance of something happening. When we predict we are usually going with our gut or feelings. The important aspect of trend following is never to have feelings or emotions about the market. Just use the price as truth, define the probabilities and make choices based on a defined system.
So, what is a system around price and probabilities? The simplest and most commonly used system in trend following is using moving averages of price to identify the trends.
Let’s look at some examples:
Below is a chart of the S&P 500 index over all of 2021.
We can see the pattern is almost a straight line from the bottom left to the top right. If one had bought on Jan 1 and sold on Dec 31, one would have generated a return of +26.9% in that time. Of course, 2021 was a good year for the stock market. So, it’s all good.
Let’s look at the chart for 2022 year-to-date:
It looks the reverse of 2021. If one held the S&P 500 index Jan 1, 2022 and held it to date, one would have lost -17.9% in that period. That very much wipes out much of the 2021 gains.
We can use moving averages to avoid this situation. Below is the S&P 500 price chart of 2021 with the 50-day moving average (purple line) plotted on it.
We can see the price touching the 50-day moving average several times. On some occasions, the price breaches it and then bounces back. In Sep the breach was deeper than other times. So, if we create a trend following system around the price movement and 50-day moving average, we should be able to mitigate the risk. This is done by buying when price is above 50-day moving average and selling when the price crosses below the 50-day moving average. This does deliver several false actions (look at March, June and Dec) but potentially saves money in the big dip of September.
The strategy helps much more in 2022 (see below)
I have added 2 yellow markers to indicate how this system would have helped get out of the market to avoid big losses.
Note that I used the 50-day moving average to illustrate the power of trend following. One can use other time frames as well. I tend to look at several - 10-day, 20-day, 40-day, 50-day, 100-day and 200-day. One could also define a system using a combination of the moving averages. I often use the crossovers of 10-day and 20-day moving averages to trigger actions. That means buy when the 10-day crosses over the 20-day and sell when the 10-day crosses below the 20-day.
On the face of it, this may seem to be too simple to be true. I encourage everyone to do their own back testing and see what the results would have been. I have been using my trend following system for several years now and it works for me. There are other aspects to my system that helps me do better than the market. I will cover these another time.