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 March 2008 Follow the Numbers Two Sets of Results from Our Technical Indicators
Quantitative investing uses a bit of both, but generally tends to lean towards the technical. Our large cap quantitative models are derived from regression analyses based on fundamental factors while our multicap and balanced quantitative models are based on regressions of historical returns and correlations. Neither is purely technical.
Truly technical investing is typically most appropriate for traders rather than longer-term investors. At bottom, it's really a function of supply and demand for shares. It's based on movements and changes in the market itself rather than any individual security. The underlying assumption is that market trends and patterns repeat and are investable. Our technical index is based on nine of factors including new highs and lows, weekly changes in the advance/decline line, and a modification of the Dow Theory applied to two of our fundamental models. The index was modified in May 2005 to offer more sell signals. Until that time it had been too bullish even when market conditions turned bearish. After seven years -- a bear market, a long-running bull market, and now, perhaps, a bear market again -- it's time to look back to see how the technical index has reacted, especially after the 2005 tweak. The answer depends on how the index is put into practice.
One Index, Two Applications On the other hand, the revisions allowed the index to send a third signal: Hold. Its addition was based on the belief that markets don't turn on a dime. Before reversing course, crosscurrents begin to rise and indicators become mixed. Then, if the market's really reversing, they eventually begin to favor the turn and the transition is complete.
We felt this more accurately reflected what actually occurs. Not only that, there are times when markets stall, yet the long-term trend remains intact. In those situations, the "hold" or "neutral" reading suggests that all indicators are no longer pointed in the same direction, yet there isn't yet a clear reversal. When that happens, you may not yet want to sell (or buy), but you should be ready to. This additional rigor also suggested a second way to read the signals. Rather than a simple buy/sell regime, a more sophisticated buy, sell, short approach was now possible. Obviously when there's a buy signal, you'd want to be long. When the indicators go neutral, you'd actually sell and go to cash to avoid any sudden downward shift. Whenever the indicators issue a true sell signal, you'd actually want to short the market to bet against a bearish trend. The goal of this second approach is to profit in all market conditions. In addition to being long when the trend is up, you can also profit by being short when the trend is negative. During those times when the signals are neutral, you can protect your portfolio by going to cash. This allows you to avoid the increased volatility while locking in money market returns. You might think conservative investors would favor the first approach over the second, but that's not necessarily the case. By periodically going to cash during periods of volatility, they may actually be more comfortable with the second approach. Of course there's always the stigma of shorting, which many investors feel is inherently more risky than always being long, but that's not always the case, either. Think back no further than the bear market earlier this decade as a prime example. Throughout 2001 and 2002 investors would have fared much better by being short the market rather than being long or even in cash. When it works properly, the second approach can boost long-term results. Which, of course, raises the critical question: Does either interpretation of the technical index provide superior results relative to a simple buy and hold approach?
Looking Back Ten Years We treated the periods out of the market as returning money market rates. The 3-month Treasury bill rate was the proxy. For the Long/Short approach, we used the negative of the actual S&P 500 return as the short return. There was no adjustment for transaction costs, either long or short, so our results don't truly reflect those of an investor following either set of technical recommendations.
Although these are simplifying assumptions, they don't really distort the study. Most money market funds closely track the 3-month T-bill. Shorting the S&P 500 no longer carries the costs of the past. With inverse funds and ETFs, margin accounts and margin calls are no longer issues. While it's true that an investor following the technical signals would incur transaction costs, they wouldn't have the same impact they once did. Not only that, they would apply to both approaches, so the comparison without them is still valid. Initially one might expect the Long/Short strategy to involve more transactions and associated expenses. Rather than just relying upon buys, sells, and money market purchases, it also includes additional purchases for short sales. Looking at the historical results, this was indeed the case. Over the 10+ years, the Long/Short strategy had nine transactions versus the Buy/Hold's eight. This makes sense when you consider it has long sales go into cash investments before (possibly) going short. The Buy/Hold approach is either long or in money market. But just one additional transaction? That's hardly a reason to be concerned. Were they worth it? That all depends on your perspective. Neither technical strategy outperformed the S&P 500 over the full 122 months. Cumulatively, the index gained 39%, Long/Short 24%, and Buy/Sell 19%. Charts 1 and 2 show how they got there. But this isn't the entire story. The charts are actually pretty telling. Consider the Buy/Hold strategy as reflected on Chart 1. It started 1997 closely tracking the gains of the index, but was slow to reverse from the late-year sell signal. Because of this, it stayed in cash for most of 1998, missing the big runup. When there finally was a buy signal, it came in the final days of the internet bubble just as the market turned south. The next sell signal came in late 2000 and did spare some additional losses. In fact, the Buy/Sell strategy came within a few percentage points of the S&P 500. But again, the buy signal came late. Stocks had already shot off into the new bull market a month or two before the strategy joined in. That difference, was never recouped in the following five years. The Long/Short strategy has a similar pattern in the early years. The sell signal lasted too long, leaving it in cash while stocks were climbing from late 1997 into late-1998. When the buy signal came, stocks were already turning down. As with the Buy/Hold strategy, the 2000 move into money market offered some protection from additional losses, but this time there was a difference. The sell signal in mid 2001 simply kept the Buy/Sell strategy in cash, but the Long/Short strategy shorted the market, and by January 1, 2002 was actually slightly ahead of the S&P 500. In short, the indicators worked. Unfortunately, the transition from "sell" to "buy" is longer for the Long/Short strategy, so it too fell behind the index when stocks entered the bull market. There is, however, one major difference and it's occurred in the past few months. At the end of the week of November 16, 2007, the Long/Short strategy shorted the market. Through the end of February 2008, it was still short. This has enabled it to dramatically close the gap with the index. Again, the signals are working. Not only that, they have probably been working better than you might guess from Charts 1 and 2. In fact, take a look at Chart 3. It again compares the Long/Short strategy with the index, but over a different time period: April 26, 2002 through February 22, 2008. That's quite a different picture. The dates aren't random or cherry-picked; they're covering the time from the changes to the technical indexes. Over that period, the Long/Short strategy cumulatively gained 82% versus 26% for the index. Although not shown on Chart 3, the Buy/Sell strategy didn't do too poorly either, gaining 58%.
Does It Work? But Chart 3 doesn't lie, either. If you initiated either technical strategy in the last week of April 2002, you'd be well ahead of the benchmark. Those transaction charges wouldn't seem too onerous, either, if you were gross returns were either 82% or 58%. Obviously the specific time period has a great impact on the result. The technical strategies won't work all the time, but when they do, they work quite well. The problem is, you can't know in advance if you're standing on the eve of a good period or bad period. This shouldn't be the case with a truly reliable model. Another thing that seems fairly apparent is that although there were commendably few buy and sell signals over the past ten years, their timing left a little to be desired. The Buy/Sell strategy always appears to be a few months too late in either direction. The Long/Short strategy is sometimes paralyzed in neutral -- between being long and being short. To its credit, when it finally goes one way or the other, it tends to do well, it just takes too long to get there. One way to speed the transition from buy to sell and vice-versa is to lower the requirements for the call. On the other hand, that's also a good way to jack up the trading costs and risk of being whipsawed in a volatile market, neither of which is desirable. Another alternative would be to keep the current levels, but tweak the indicators. The directional bets are correct just slow, so if it was possible to substitute indicators that were more sensitive to the forthcoming change in market direction, the signals could come sooner but not more frequently. That's an alternative that's worth pursuing. Unfortunately, the data here doesn't offer much to help in that regard. The current indicators are based on internal market characteristics, the very basis of most technical analysis. Perhaps different internals might be more telling. That's what we'll look into over the coming years. At this point we're happy leaving the buy and sell signals as they were in April 2002. They seem to work, just too slowly. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
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HERE ARE TWO BASIC approaches to investing: Rely on securities' specific characteristics for buy and sell decisions, or look instead to the market itself. The former is know as "fundamental" investing while the latter is "technical".
