Editor’s Note: At this point a lot of ink has been spent on whether stocks are really cheap and if the market will now rally from here. Of course “time will tell” but in order to make money we need to know the answer before that. My personal gut feeling is that we still have another leg down but wouldn’t it be nice to have a more scientific approach than just your “gut feel”? Of course we have our ROC indicators (see our NYSE ROC and our NASDAQ ROC) but if you would like another opinion for full confirmation, here is Rick Pendergraft’s simple market timing tool.
By Rick Pendergraft
One of the things I have been asked, and have seen in headlines over the last week, is whether or not this rally is for real. My answer? It’s too early to tell.
A few weeks ago in the State of the Market special report, I cautioned the bears to look out for a sharp rally. The market was just looking for an excuse to rally. Enter Citigroup (which I suggested was worth taking a flier on in last week’s article) with word that they made money in the first two months of the year.
Here is what I would suggest. First, if you are looking at the short-term, I would look for the market to continue to rally over the next few weeks. Getting the indices out of the historic oversold level we reached a few weeks ago. Second, if I am looking at the long-term, I might be wading in at this point, but I would not be diving in headfirst with all my money allocated to stocks.
I know many investment professionals say you shouldn’t try to time the market, but I have to disagree with them. You don’t have to time the tops and the bottoms, but you certainly should be adjusting your asset allocation based on whether or not we are in a bear market or a bull market.
How do you know which one we are in? There are hundreds of answers for that, but a simple one that I have been using and testing is a crossover of the 6-month and 12-month moving averages for the S&P 500.
Look at the chart below. Over the last 20 years, had you loaded up on stocks when the 6-month crossed above the 12-month, you would have been heavily allocated to stocks from late 1994 until late 2000, heavily allocated to bonds from 2000 until early 2003, back into stocks from 2003 until early 2008, and then back to bonds. Is it perfect? Of course not. It doesn’t get you in at the exact bottom and it doesn’t get you out at the exact top. But it does have you in for the bulk of the move.
How effective would this S&P timing signal have been over the last six years? Well I looked at three portfolio scenarios after the last bullish signal in early 2003 until the end of 2008.
Scenario 1-all money was put into four equity ETFs- the Diamonds (the Dow), the Spyders (the S&P 500), the QQQQ (the Nasdaq 100, and the IWM (the Russell 2000). There was no timing used in this scenario, it was strictly buy and hold.
Scenario 2- 80% of the money was put into the four equity ETFs in scenario 1 and the remaining 20% was put into three different bond ETFs. This scenario also used a buy-and-hold strategy.
Scenario 3- using the simple timing mechanism mentioned above, 80% of the portfolio was in the four equity ETFs and 20% in the bond ETFs until March 2008. At that time, the funds were reallocated to 30% in the four equity ETFs and 70% went into the three bond ETFs.
So how would you have fared using this strategy? Look at the chart below. Assuming a starting value of $1,000,000, at the end of 2008, your buy and hold strategy for stocks would have produced an overall gain of 14% and the buy and hold strategy with bonds and equities would have gained 19%. The clear winner was the one that used the timing mechanism. This strategy would have produced an overall gain of 52%.
Notice on the chart how Scenario 3 trails the other two ever so slightly for the first four years, loses ground in 2007, but saves you massive pain in 2008.
Getting back to the original theme, as a short-term trader, I would be playing the long side of this market for the next few weeks with an eye on the earnings season that will start in approximately three weeks. As a long-term investor, I would be dipping my toes in the water for now, but I would wait for confirmation of the 6-month moving average crossing back above the 12-month moving average before changing my asset allocation back to mostly equities.
Good luck and good trading,
Rick
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