The Most Profitable Market-Timing System I Know

Imagine a market strategy that did 11 times better than buy and hold and never experienced a down year. With perfect market timing, that’s as good as it gets.

Traders that avoided every losing year in the stock market since 1970 would have made 11 times more money than buy-and-hold investors. A “perfect timing” trading system would have returned about 15.9% a year while the buy-and-hold investor would have gained about 9.5% a year including dividends.

Perfect market timing is impossible to do in real time because no one can consistently pick tops and bottoms. If they could, they would need to be fairly active. Stocks, as measured by the S&P 500 index, have changed direction more than 10 times in the past 10 years, using a move of at least 10% to measure the major trend.

In real time, the best that most traders can expect is to participate in the market gains after the trend has started and sell after the down move has begun. In this case, market timers would focus on reacting to what the market is doing rather than predicting how it should move in advance. There will be losing trades, but the successful timer will catch most of the long-term trends.

A drawback of this strategy is that using price to decide when to buy and sell guarantees that traders will be at least a little late at all major market turns. By waiting for prices to decline before selling, traders will always have to give back some of the profits made on the up move.

One tool that can help traders get closer to timing the tops and bottoms is momentum. Using momentum measures, it’s possible to get out of the market before a decline starts, and buy signals can come while the bottom is still forming. Momentum can be measured in various ways but all of the different indicators show how fast a stock, mutual fund, or ETF is moving. The simplest way to measure momentum is with the rate of change (ROC) indicator.

ROC measures the percentage change in price. Any time period can be used in the calculation, but we will look at the 6-month ROC to spot trade signals. The ROC usually rises along with price. In a healthy bull market, this confirms the up trend and makes the decision to let winners run easy to implement. As prices near a top, the ROC often slows down before prices fall and using this indicator can help you sell before the price decline even starts in some cases.

In 2007, stocks in China moved up in price quickly enough to be considered a bubble by many observers. ROC started falling near the top in price, and that would have been a timely exit signal for traders.


In this case, a moving average has been added to the ROC indicator to help time the sell. This system alone can have false signals and additional filters should be applied to this strategy to develop an effective trading system.

ROC can be used to create a market-beating trading strategy. Using this powerful idea, we are now watching the stock market from the sidelines. The S&P 500 has been on a sell signal since March, which means we have been able to find better investment opportunities than the U.S. stock market. The index fell as much as 15% after the sell signal was given and over the last nine months of 2011, the S&P 500 was flat.

 

ROC for the S&P 500 is negative and that indicates the risk of owning stocks is high. The indicator has also been below its moving average for most of 2011.

The signals from the 6-month ROC system will not be perfect and there will be losing trades. But since the beginning of 2007, the 6-month ROC system has delivered an annual return of about 14.7% a year, very close to the long-term record of perfect timing which gained 15.9% a year. With this system, we buy the three ETFs that have the highest ROC over the past six months.

Right now,  my 6-month ROC strategy says that traders should be holding iShares Lehman 7-10 Year Treasury (IEF), iShares Barclays 20+ Year Treasury Bonds (TLT), and iShares iBoxx Investment Grade Corporate Bonds (LQD).

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