The Market Timer: Analysing Mr Market

PORTFOLIO POINT: Try this simple exercise of timing the share market yourself. It won’t make you an expert, but it will teach you the fundamentals of trend following.

When our signal moves it means a lot to us. And after a very quiet period that’s just what happened with our key signals – including our “Active timing strategy” changing to a Buy. To put these moves into perspective, there had been Sell signals on key strategies ranging back as far as May.

What drives these changes? At marketiming.com.au our computer has a control panel of seven proprietary technical indicators, plus stop loss safety limits for signalling when to be in or out of the stockmarket.

These signals are generated automatically and independently of what any of us might personally think Mr Market will do next. That’s important because we want our computer to objectively gauge what this wily character is actually doing and not be influenced by media or other human reactions to his manic behaviour.

Our mission is to beat Mr Market at his own game by understanding his direction and momentum. When he’s charging forward full of gusto we back him, but when his energy flags and he starts stumbling we abandon him. Sound cruel? Absolutely, since Mr Market has no compunction in dumping us if we follow him like a lemming.

While we should have no lasting loyalty to Mr Market we must always respect his will. Thinking we can defeat him is pointless. Like running with a bull, we must be alert to when Mr Market turns vicious and get out of his way. Otherwise he will draw blood.

So how can we gauge his direction and mood? You can try a basic do-it-yourself approach using the free charting software available at the websites of most leading stockbrokers.

Alternatively, take a minute and let me go through a demonstration using just two technical indicators – an Exponential Moving Average (EMA) of the S&P 500 Index, and a measure of momentum. In this instance we have set the moving average at 20 days, but research shows that following a moving average of anywhere between three and 300 days and still beat buy and hold over the long run.

In the chart shown below, the 20-day exponential moving average for the index at any date represents the average of the closing values of the index for each of the preceding 20 trading days with greater weighting given to recent index values than older ones. The moving average reveals the index’s underlying direction or trend over time. It’s depicted by the red line. When it’s rising Mr Market is bullish and when it’s falling he is bearish.

The terms bull and bear give an emotional dimension to Mr Market’s personality. When he’s charging forward he is akin to a raging bull, but when he’s retreating he is a grizzly bear. Our strategy is to chase him when he is running ahead, but steer clear when he reverses direction or holds his ground.

The momentum indicator below the chart is simply the rate of change in the index over any 12-day period. It can be positive (bullish) or negative (bearish). When Mr Market is charging forth at an accelerating pace the momentum indicator is positive (above zero) and rising. When he stumbles and falls, the momentum indicator too drops and goes negative (below zero).

If you have kept up so far you are now ready to time the market using this crude model. Here are some rules for doing so.

When the market index is above its 20-day moving average treat that as bullish. When it is below this moving average, treat it as bearish. Look carefully at the above chart which covers the period from January 1 to April 30 2009. Notice that in January 2009 the market (or the S&P 500) fell below its red trend line (the 20-day moving average), but then temporarily spiked above it in late January and early February. Thereafter the market plunged before recovering strongly after mid-March 2009.

If you had bought and sold shares in iShares ETF based on the S&P500, available on the ASX under the code IVV, according to whether the blue line was above or below its moving average you would have been whipsawed twice in January and February (false signals) before you made the right move (in March).

But you could have avoided one of those two whipsaws by looking at the momentum indicator below the chart. When it was positive Mr Market was still full of energy, but when it was negative he was out of puff.

Note that in late January 2009 Mr Market briefly ran above his red trend line, giving hope he was on the mend. But a quick glance at his momentum showed he did not have the stamina to keep going. That proved correct since next he fell below his trend line and his pace became erratic.

By early February he again surged above his red trend line and for three days his pace proved positive, too. That triggered a Buy signal on this crude model. The result was a whipsaw since Mr Market soon faltered both on direction and pace (which would then have produced a small capital loss).

Selling out of shares (even with a small loss) at that point nevertheless proved a blessing since Mr Market not only stumbled but plunged into a deep gully. By mid-March he had recovered from his fall, climbed above his red trend line and exhibited positive momentum. So it was time to back him again by buying shares at a lower price than what you sold them for in early February.

Besides obtaining shares at bargain basement prices you would also have been out of the market when it was in freefall, but got back in time to enjoy the fastest rally since the Great Depression, something very few financial commentators foresaw.

So there – you now know how to crudely time the market.

Now that you understand how a crude market timing model works, you should have a good gist of what trend following is about. Unlike other investment strategies it doesn’t involve forecasting Mr Market’s intentions, which is a dangerous game because no one knows what he is planning tomorrow, let alone in a year’s time.

Instead it’s about gauging his present direction and momentum. From studying his past form we know there is only one certainty about his otherwise erratic behaviour: over 20 days or more he tends to run in the same direction for three-quarters of the time.

So by following his direction (the trend) and watching his pace (momentum) we can back him when he’s a winner and shun him when he’s a loser. There will be times when he fools us, but our model is programmed to cut short any losses while letting profits run.

That’s why it’s beaten him over the long run. Yet it’s not so smart it can beat him at every post, which means we need to be patient and not let short-term setbacks discourage us. Instead, we must follow every signal whatever we personally think Mr Market will do next.

Percy Allan is chairman of Market Timing Pty Ltd and its chief spokesman.