Does Market Timing Work?

If you've ever met a mutual fund salesman representative you have probably been told that market timing does not work. The statements often sound like this:

"The biggest potential pitfall in trying to time the market is missing the days it’s “up.” In fact, if you had missed the stock market’s 10 best days over the past decade, you would have lost nearly 5% of your original investment." - American Planners (pdf)

"Missing only the 5 best months over a 30-year period could have a significant impact on your overall returns; missing more than that could have an even greater negative effect." - ING (pdf)

A recent paper by Mebane Faber ("Where the Black Swans Hide & the 10 Best Days Myth") illustrates that market timing works and the above statements are misleading. The half-truth in the above quotes is that the market's best days are not randomly distributed. Rather, so-called "best" days are bear-market rallies that tend to cluster in times that the market is going down.

The past year provides a perfect example. In the chart below we see that the S&P 500 was up nearly 4% in each of the two "best days". Missing these days would surely be catastrophic, right? Not really. In fact these two days were clustered among the market's four worst days. And, just as predicted, it is a bear market and the index sits below the 200-day moving average.

Just as we saw in the chart above, Faber's study identifies that both "best" and "worst" days occur during volatile bear markets. But, for investors who use a market timing signal returns are higher than buy-and-hold with less volatility. To quote the author:

"Our central argument is that returns improve and volatility is reduced when an investor is invested in uptrending markets thus avoiding the volatility and clustering of best and worst days inherent in declining markets."

Using price data for the S&P 500 between 1928 and 2010, Faber calculated the performance of two portfolios: Buy and Hold versus Market Timing. In the market timing strategy the portfolio was invested only during advancing markets, when the price was above the 200-day simple moving average (similar to Weinstein's stage analysis that I describe here).

Results of Buy-and-Hold versus Market Timing of the S&P 500 (1928-2010)

Strategy	Annualized Return	Annualized Volatility	Return/ Volatility
Buy-and-Hold	4.86%	18.34%	0.26
Market Timing (Price > 200 SMA)	10.29%	14.32%	0.72

Mechanical market timing substantially out-performed buy-and-hold. Users of the timing model were better rewarded for the volatility they experienced. Faber goes on to perform this analysis on 14 other markets and in every case timing the market beat buy-and-hold.

If you missed the best 1% of all days your return gets crushed from 4.86% down to -7.08% per annum. [...] Most analysts, unfortunately, stop here and throw up their hands. They proclaim buy and hold to be the only way to ensure being in the market for these best days. [...] They take the ball all the way down to the five yard line but stop there. -Mebane Faber

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