Prepare for the Next Bear Market with This Simple Market Timing Model

Leading into the market crash and bear market of 2008 and 2009, I was just beginning to learn about investing, trading and the financial markets. During this time, I took an interest in the work of Mebane Faber, who wrote a research paper about a very simple timing model to significantly improve the risk adjusted returns of long term investments.

Using this timing model, I took the S&P 500 index fund in my retirement account to cash when it hit the 10 month moving average. This single action prevented significant losses. Ever since, a variation of this timing model has been a mainstay of my long term investment strategy. Investing in the S&P 500 index is a simple example, but the timing model is also robust enough to work with different asset types, such as commodities and bonds.

A Simple Timing Model to Avoid the Worst of a Bear Market

Let’s assume you have your retirement account invested in an S&P 500 index fund, such as the Vanguard’s 500 Index Investor Fund (VFINX). A simple timing model basically works as follows:

That’s it! If you back-test this simple strategy all the way to 1995, you can see the performance of this timing model through two different bear markets, and compare it with a buy and hold strategy:

Below is a chart which also illustrates the performance of this simple timing model versus a buy and hold strategy:

Using a timing model, not only do the annual returns (CAGR) improve somewhat, but the maximum drawdown and worst year’s performance significantly improve!

The Importance of Investor Psychology

An investor using a buy and hold strategy from very top of the market in 2007, to the very bottom of the bear market in 2009 would have seen a drawdown of over 56%. On the other hand, someone who used a simple timing model would be in cash through the worst of the bear market.

In the long term, the annualized returns (CAGR) of a buy and hold strategy are not significantly different than a simple timing model. However, in the midst of a market crash and bear market, a 55% drawdown can be devastating to an investor’s psychology. For example:

If It’s So Simple, Why Isn’t Everybody Doing It?

The timing model discussed herein is as simple as can be. However, putting this timing model into practice over a long period of 20 to 30 years is hard. It again boils down to psychology, but some reasons a system like this is difficult to implement include:

Even though the implementation of a timing model over the long term can be challenging, there are a number of ways to persevere with a system like this. For example:

Now is the time to Prepare for the Next Bear Market!

After the market crash in 2008 and low point in March of 2009, the stock market has been in an extended bull market. At the time of this writing (November, 2018), there’s no predicting when the next bear market will occur; the only certainty is that a bear market will return at some point.

A key message from personal self defense training is to prepare yourself and know how to react before you are faced with a worst case scenario. I believe this type of message applies equally to investing. You need to prepare yourself beforehand, rather than make hurried and emotional investment decisions in the midst of volatile and rapidly deteriorating market conditions.

The timing model discussed herein offers investors a simple and time-tested strategy to achieve superior risk adjusted returns. Versus a “set it and forget it”, buy and hold type strategy, these types of systems do require more patience and discipline to implement. However, for many individual investors, it is definitely worth the extra effort to minimize risk exposure while still achieving very respectable investment returns.

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