Chart 7: Time periods invested in T-Bills when following the SYD short strategy.
When we examine the data, the moves into treasuries worked out well in 1983 and 1990. These were periods when treasury yields were quite high so substantial returns could be gained in treasuries while equities suffered as predicted. However, the moves into treasuries in 1997 would have missed out on the strong gains in equities from 1997 to early 2000. This might be tolerated by the investor since the market suffered a steep decline in later 2000. The investor would have been shielded from this decline. However, this occurrence demonstrates an issue with attempts at market timing. While the investor would have missed the steep decline in mid-2000, they also missed out on the strong equity run-up of the previous three years. These models can't predict when the top of the market will occur - they merely indicate when the opportunity for returns might be better in treasuries versus equities. Often, the equity market will continue to rise after this indication and then will decline in value until equities appear more attractive. So, the model will cause investors to miss some of the climbs to the top of the market while they are invested in lower performing treasuries. Now, it is worth remembering that the value of equities is measured not only by price appreciation but also by dividends earned when holding the equities. Thus, it turns out that missing out on the dividend yields from the equities was the reason why holding treasuries during this period (1997-2000) didn't result in a greater return. Treasury yields were quite low during this period. Thus, it seems that the SYD works fairly well when the absolute treasury yields are on the high side. Otherwise, the potential to miss out on dividend payments while sitting out the ride up and down of equities might end up being more painful to the investor.
So, we have found some fundamental problems with this model. First, it will cause investors to miss out on some potentially valuable equity run ups. That might be acceptable if the returns of the treasuries would more than compensate for lost dividend payments. But, this model doesn't consider the rate of dividend payments or the absolute level of treasury yield. Perhaps some improvements on the model (increasing its complexity) would produce more positive results? Perhaps not?
While we have focused on only one core market timing strategy, we do think that it has pointed out some of the pitfalls and challenges of market timing-based investment strategies. In fact, the SYD strategy is one of the few strategies which has some evidence pointing out that it may work (although we do doubt the validity of Shen’s analysis). There are a few caveats that we should mention about our analysis. First, since, the average annual return of treasuries is substantially lower than domestic equities (represented by the S&P 500), it may be difficult to construct an asset allocation strategy which uses the safety of treasuries to increase returns. These strategies seem to effectively increase Sharpe ratios but gaining an edge in returns may prove very, very difficult. However, if we explored moving funds into an asset class (like foreign equities) that have return characteristics closer to domestic equities then we might find some success. However, it is likely that a model shifting allocations between two asset classes with similar return characteristics would produce its fair share of issues that might hamper returns versus a strategy of fixed allocation with periodic rebalancing.
As Charles Ellis points out “the evidence on investment managers’ success with market timing is impressive – and overwhelmingly negative”. Most logical market timing ideas actually perform worse than our recommended strategy of picking an asset allocation and maintaining it. Without doubt, we think that there are some more sophisticated models which can probably slightly increase your long term returns. However, we don’t recommend attempting to time the market or apply tactical asset allocation. It is difficult to find a model which will perform well in future periods (versus simply testing well on historical data).
Your best bet is to determine some fixed allocation percentages among asset classes and to rebalance periodically.
Chris Brooks, Apostolos Katsaris, and Gita Persand. “Timing is Everything: A Comparison and Evaluation of Market Timing Strategies”. 2005
Charles Ellis. Investment Policy. 1985
Pu Shen. “Market Timing Strategies That Worked”. 2002.
Wong, W.K., Vhew, B-K., and Sikorski, D. “Can the Forecasts Generated from E/P Ratio and Bond Yield be used to Beat Stock Markets?”. 2001