Buy and Hope? Part 2
Alternative strategies for prudent investors
Leigh Anderson <[email protected]>
Presentation at www.tayara.com/hia
Today’s Discussion
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“Buy & Hold”
• Hold a portfolio of diversified assets, in fixed proportion
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E.G., 60% stock, 40% bond
• Rebalance periodically
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Risks are greater than previously perceived
• Long periods where returns are lousy
• Large drops in portfolio value possible
• Buy-and-hold investors have effectively lost at least a decade
of accumulated wealth.
• History offers many examples of markets that have spent a
quarter century or more mired in a trough.
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Can investors improve results with “active” strategies?
• In particular by timing or dynamically switching assets
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Look at one simple system based on moving averages
What is the evidence for/against?
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Conventional Wisdom
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You can’t successfully
time the market
"It's one thing to get
out of the market at
the perfect time,"
says John Bogle, "and
quite another to get
back in at the perfect
time. - how many
people can do that? You've got to be right
twice."
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Conventional Wisdom
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To be successful, traders must repeatedly overcome
numerous costs associated with trading.
Research indicates that professionals are poor short-term
prognosticators.
Market timing is generally a losing activity
You have to be in the market to profit
• if you removed the 10 best days for the Dow Jones Industrial
Average in the 1900-2008 years, two thirds of the cumulative
gains were lost.

But nobody ever tells you that
• if you missed the 10 worst days, the actual gain on the Dow
tripled.
• stocks fall a lot faster than they rise.
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Mebane Faber
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“A Quantitative Approach to Tactical Asset
Allocation”, Mebane T. Faber, Spring 2007,
The Journal of Wealth Management,
February 2009, Update
A very simple strategy based on moving
averages
• Simple, purely mechanical logic.
• The same model and parameters for every
asset class.
• Price-based only.
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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The 200 Day Simple Moving
Average (SMA)
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The 200 day SMA is the
average of the price for
the preceding 200
trading days, plotted
against today’s price
(200 trading days = 10
months)
Yahoo Finance
http://finance.yahoo.com/

Click on S&P 500
Or enter symbol of an ETF
or mutual fund


Click on “Basic Technical
Analysis”
Click on “Moving Avg
200”
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Faber’s Trading Rules
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BUY RULE
• Buy when monthly price > 10-month SMA.
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SELL RULE
• Sell and move to cash when monthly price <
10-month SMA.
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Note:
• The model is only updated once a month on
the last day of the month. Price fluctuations
during the rest of the month are ignored.
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Faber
Timing Strategy:
100% stock if P > 10mo SMA
100% cash if P < 10mo SMA
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Faber
Exit
Exit
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Are We “Data Mining”?
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Have we tried so many systems,
rejecting the ones that don’t work,
until we found one that works by
chance?
Possible tests for data mining:
• Try system on different assets
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Non-US stock, real estate trusts (REIT),
Bonds, commodities
• Try different averaging lengths
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9 May 2009
Something magic about 200 days?
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Various Moving Average Timing Lengths
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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International Stocks
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Multiple Asset Classes?
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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What if we apply to multiple
invest.ments (asset classes)?
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Apply timing rule to five asset
classes, independently
• S&P500, EAFE, NAREIT, 10yr bond,
GSCI, over 1972-2005
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Professors say: Technical Analysis Doesn’t Work
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The Disappearance of Momentum
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Technical Trading Revisited: Persistence Tests, Transaction Costs, and False
Discoveries
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We investigate the robustness of the momentum premium in the US over the period from
1927 to 2006 using a model that allows multiple structural breaks. We find that the risk
adjusted momentum premium is significantly positive only during certain periods, notably
from the 1940s to the mid-1960s and from the mid-1970s to the late 1990s, and we find
evidence that momentum has disappeared since the late 1990s. Our results further suggest
that momentum profits have been slowly eroded away since the early 1990s, in a process
which was delayed by the occurrence of the high-technology stock bubble of the 1990s. In
particular, we estimate that the bubble accounted for at least 60% of momentum profits
during the period from 1995 to 1999.
We revisit the apparent historical success of technical trading rules on daily prices of the Dow
Jones index. First, we use the False Discovery Rate as a new approach to data snooping. The
advantage of the FDR over existing methods is that it is more powerful and not restricted
only to the best rule in the sample. Second, we perform persistence tests and conclude that
an investor would not have been able to select ex ante the future best-performing rules.
Finally, we show that the performance fully disappears once transaction costs are taken into
account.
Technical Analysis Around the World: Does it Ever Add Value?
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Technical analysis is not consistently profitable in the 49 countries that comprise the Morgan
Stanley Capital Index once data snooping bias is accounted for. There is some evidence that
technical trading rules perform better in emerging markets than developed markets, which is
consistent with the finding of previous studies that these markets are less efficient, but this
result is not strong. While we cannot rule out the possibility that technical analysis
compliments other market timing techniques or that trading rules we do not test are
profitable, we do show that over 5,000 trading rules do not add value beyond what may be
expected by chance when used in isolation.
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Professors say: Technical Analysis Works
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Re-Examining the Profitability of Technical Analysis with White’s Reality Check and
Hansen’s SPA Test
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In this paper, we re-examine the profitability of technical analysis using White’s Reality Check
and Hansen’s SPA test that correct the data snooping bias. Comparing to previous studies, we
study a more complete “universe” of trading techniques, including not only simple rules but
also investor’s strategies, and we test the profitability of these rules and strategies with four
main indices. It is found that significantly profitable simple rules and investor’s strategies do
exist in the data from relatively “young” markets (NASDAQ Composite and Russell 2000) but
not in the data from relatively “mature” markets (DJIA and S&P 500). Moreover, after taking
transaction costs into account, we find that the best rules for NASDAQ Composite and Russell
2000 outperform the buy-and- hold strategy in most in- and out-of-sample periods. It is also
found that investor’s strategies are able to improve on the profits of simple rules and may
even generate significant profits from unprofitable simple rules.
MARKET-TIMING STRATEGIES THAT WORKED
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In this paper, we present a few simple market-timing strategies that appear to outperform the
“buy-and-hold” strategy, with real-time data from 1970 to 2000. Our focus is on spreads
between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as
compared to their historical ranges, appear to predict higher frequencies of subsequent
market downturns in monthly data. We construct “horse races” between switching strategies
based on extremely low spreads and the market index. Switching strategies call for investing
in the stock market index unless spreads are lower than predefined thresholds. We find that
switching strategies outperformed the market index in the sense that they provide higher
mean returns and lower variances. In particular, the strategy based on the spread between
the E/P ratio and a short-term interest rate comfortably and robustly beat the market index
even when transaction costs are incorporated.
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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What’s going on?
The “Proof” Dilemma
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Same data (historical stock record) is used both to discover
rules, and to test them
Analogy to drug testing: imagine using different
experimental drugs on same patients, over and over
To compensate for lack of independent stock price data,
statistical techniques become very blunt instruments.
• Not sensitive enough to prove success
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To a statistician, if you can’t prove the positive, then you
have to assume the negative (the “Null Hypothesis”)
• Assume that a drug doesn’t work and try to prove that it does
• Failing to prove that it works is not the same as proving it
doesn’t work
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Question: suppose someone gave you a method that had a
3 in 4 chance of success, with little downside. Would you
use it?
9 May 2009
Houston Investors Association / Getting Started SIG / Leigh Anderson
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Support for Technical Analysis
Technical Analysis: The
Complete Resource for Financial
Market Technicians by Charles
D. Kirkpatrick, Julie R. Dahlquist
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Caveats for Faber Strategy
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Faber paper is in “Top 5 Papers” at SSRN
Taxes and transaction costs: Turnover 70%
A trend-following will underperform buy and hold during a bull
market but avoids lengthy bear markets.
• Consequently, the value added by timing is evident only over the
course of entire business cycles.
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Psychological Requirements
• Patient, determined, disciplined and persevering
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Have to wait for indicators to move into a pattern that signals a buy or sell
decision.
Determination and discipline to stick to strategy, persevering despite
setbacks
• Independent — Many people will offer advice, opinions and criticism.
• Realistic — Sometimes buy and hold will outperform timing
• Decisive — People who see-saw between alternatives never taking
action can’t time successfully
• Emotionally steady — People who let their emotions carry them away
should not try to time the market.
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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References
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“A Quantitative Approach to Tactical Asset Allocation”, Mebane T. Faber, Spring 2007, The Journal of
Wealth Management, February 2009, Update
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461
Faber, Mebane T.,A Quantitative Approach to Tactical Asset Allocation(February 17, 2009). Journal
of Wealth Management, Spring 2007. Available at SSRN: http://ssrn.com/abstract=962461
Timing Is Everything Barron’s http://online.barrons.com/article/SB124061347806354619.html
The Ivy Portfolio (links) http://www.theivyportfolio.com/links/
“Trading Places” CFA Magazine, June 2009
Price Momentum -- A Twenty Year Research Effort (August, 2001)
http://www.columbinecap.com/pdf/PRICE%20MOMENTUM.pdf
MARKET-TIMING STRATEGIES THAT WORKED Pu Shen Research Division, Federal Reserve Bank of
Kansas City MAY 2002 RWP 02-01 http://www.kc.frb.org/Publicat/Reswkpap/pdf/rwp02-01.pdf
Technical Analysis: The Complete Resource for Financial Market
Technicians http://www.amazon.com/Technical-Analysis-Complete-FinancialTechnicians/dp/0131531131/
Technical Analysis:An Academic Perspective
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•
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This video by Andrew Lo (one of the heavyweights in academic finance) is well worth listening to.
http://event.on24.com/clients/default/presentation/default.html?titlecolor=000000&eventid=110220&sessionid=
7&username=&partnerref=&format=rmmulti&key=28A828822AD18023FD5FDB8F5F090792&text_language_id=
en&playerwidth=880&playerheight=640&eventuserid=16993198
It has a downloadable pdf file of slides
http://event.on24.com/event/11/02/20/rt/7/documents/slidepdf/07_andrew_lo_20080516.pdf
Is buy-and-hold dead and gone? (10/29/2008)
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http://money.cnn.com/2008/10/24/magazines/fortune/buyandhold_okeefe.fortune/index.htm
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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John Hussman
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What we can observe is that valuations are now in the high-normal range on the
basis of normalized earnings. Stocks are no longer undervalued except on measures
that assume that profit margins will permanently recover to the highest levels in
history (in which case, stocks would still only be moderately undervalued). For
instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but
those prior peak earnings from 2007 were based on record profit margins about 50%
above historical norms, largely driven by the excessive leverage that has since sent
the economy reeling.
On normalized profit margins, valuations are above the historical average, and
prospective long-term returns are below the historical average. Overall, I expect the
probable total return on the S&P 500 over the coming decade to be about 8%
annually, provided we don't observe much additional deleveraging in the economy. At
the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was
priced to deliver 10-year total returns of about 15% annually. While it has become
quite popular to talk about 1974 and 1982, the stock market is presently not even
close to those levels of valuation.
Meanwhile, market action in recent weeks has been excellent from the standpoint of
breadth (advances versus declines), uneven from the standpoint of leadership (where
much of the strength has been focused on speculation in companies with
extraordinarily poor balance sheets), and rather uninspiring on the basis of trading
volume.
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Houston Investors Association / Getting Started SIG / Leigh Anderson
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Hussman, cont
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From an economic standpoint, the main argument for an oncoming recovery is simply
that the knuckles of investors and consumers are no longer absolutely white. A
backing-off from extreme risk aversion is certainly helpful, since it puts banks at less
risk of customer flight, but the underlying assets of banks are still deteriorating. For
the time being, the recent revision in accounting rules has prevented balance sheets
from showing negative capital and revealing insolvency, but the reality is that the
mortgages underlying bank assets are still defaulting. If this was simply a temporary
problem of fluctuating asset values that would recover over time, the problem would
not be serious. … In the case of mortgages, once the loan goes into foreclosure,
there's an asset sale, the loss is taken, and the game is over.
Overall, then, the fundamentals of the market and the economy are not nearly as
positive as they are being spun by analysts. Stocks are at best only moderately
undervalued if one assumes that profit margins will recover to the historical extremes
we saw in 2007, and are otherwise mildly overvalued. The financial system is in
cosmetic remission, looking better on the surface, but still deteriorating internally.
Still, we can't discard the fact that the extreme risk aversion of recent months has
eased. Breadth has been quite strong, but is also overbought (with over 80% of
stocks above their 20-day and 50-day averages). The mixed picture offers neither
certainty that the bear market will resume, nor that a bull market will emerge.
Hussman Funds May 4 2009 http://hussmanfunds.com/wmc/wmc090504.htm
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