Timing attempts to provide market equivalent returns over the long term, with a substantial reduction in variability of returns. The two components of the Timing program are:
(1) EZ+Macro, which allocates half the portfolio between stocks and bonds. This component could be 100% long stocks, 100% long bonds, or long 50% each stocks and bonds. It does not go short. Allocations are made based on the combination of trends in the U.S. stock market and the intermediate-length U.S. Treasury market.
(2) Fear/Greed, which allocates the other half of the portfolio and switches between either 100% long stocks or 100% cash. The Fear/Greed algorithm uses abnormally high amounts of fear in the U.S. stock market as a signal to buy, and will hold until an abnormally high amount of complacency i.e. “greed” is evidenced in the U.S. stock market. Fear and greed are measured through comparing the CBOE Volatility Index on the S&P 500 (VIX) to a proprietary estimation of where the VIX “should be” based on actual price movement.
Combined, the two components of the Timing program can shift portfolio allocations into one of six different positions:
* 100% long stocks,
* 75% long stocks and 25% long bonds,
* 50% long stocks and 50% long bonds,
* 50% long stocks and 50% cash,
* 25% long stocks, 25% long bonds, and 50% cash, or
* 50% long bonds and 50% cash.
To evaluate returns, ETFs are used to track positions. The S&P 500 SPDRs (SPY) is used for “stocks” and the iShares 7-10 Year Treasury Bond Fund (IEF) is used for “bonds.”
The Timing program uses only the above two models to allocate assets in a “lazy” trading fashion.
Backtesting
While a variety of developmental tests have been done on the components of this system, some going back into the 1950s, below is presented a combined backtest of the entire system from January of 1993 to November of 2007. The total return of the SPDRs S&P 500 tracking ETF (SPY) was used for comparison, and represents the “stocks” allocation of the system. Total return for the iShares 7-10 Year Treasury Bond Fund (IEF) is used to represent the “bonds” allocation of the system. For the time period before the IEF was actively traded, the total return on an intermediate-length government bond mutual fund was used. Throughout the test, a 4% annual yield is assumed for cash positions.
The tests below assume a $10,000 investment traded according the plan, and allocated on January 29, 1993.
The majority of the benefit comes from reduction in volatility of return. Average annual and cumulative annualized returns are increased slightly, but note the 27.5% reduction in standard deviation of annual returns.
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Another measure of risk is equity drawdown. The methodology doesn’t eliminate the risk of sharp drawdowns, such as the one in 1998, but it did an excellent job of avoiding drawdown in the bear market of 2001-2002. Max drawdown for the system was 19.0%, versus nearly 50% for the S&P 500.
The equity curve shows how the method smoothes the returns over time. Note that a small increase in cumulative annualized returns, from 10.7% to 13.0%, translates into a final equity that is 31.2% larger in 13 years’ time.
