market timing (part 1)

I've been exploring simple quantitative market timing rules occasionally during the past year and the most promising I've found is related to retail sales. The chart above illustrates the S&P 500 return (adjusted for dividends as reported by yahoo finance) against retail sales as reported by the U.S. Census Bureau (payroll figures included as well for good measure). As you can see by looking at the blue circles, the last two major market peaks were foretold by a top in year-over-year retail sales. However, if you look all the way back to 1994, which is as far back as this economic data series is available electronically, you will notice there were some tops in retail sales where the S&P did NOT subsequently enter a downtrend. Just goes to show that you have to maintain your skepticism in regards to market timing rules insofar as you may discover one that is helpful, but its not likely to be fullproof.

So, would trading based on retail sales be helpful? To answer this question, I set up a back-test as follows: If the average of the trailing-2-month ("T2M") Y/Y retail sales growth figures are greater than the average trailing-12-month ("TTM") Y/Y retail sales growth figures, then buy the S&P 500. If not, then sit out of the market (and earn 0% for purposes of this test). The second chart above shows the results of this trading strategy vs. a buy&hold strategy. As you can see, the Trading Portfolio spends a significant amount of time 'out of the market' and is therefore substantially less volatile than the Buy&Hold Portfolio. Although the Trading Portfolio generates a lower total return, the dramatically reduced volatility provides for some Alpha (i.e. excess return in relation to its Beta) and a superior Sharpe Ratio. Just for kicks, I also 'tortured the data' and ran the test since 1998, thus excluding those early time periods when the trading rule wasn't very effective, the results of which are included in the table above. One day I might hand crank the test going back to 1953 when retail sales were first reported, just to gain a longer-term perspective, but of course there is no time for that sort of manual exercise today.

One thing I find interesting about these sort of quantitative timing strategies, is how they produce risk/return profiles so different from the underlying asset class, which perhaps could represent an opportunity for further diversification beyond the traditional stocks/bonds/cash mixtures.

The main thing to take away from this analysis is that in the intermediate term (2-5 years), the stock market follows macroeconomic fundamentals. Knowing that simple fact is useful for maintaining perspective and keeping an even keel whilst the daily headlines and market pundits tempt you to trade, trade, trade (usually to your detriment). Just as a side pontification, which I might elaborate upon at some point in the future, I think the market is mainly swayed by sentiment in the short term and valuation in the long term (10-20 years).