Improving on Buy and Hold: Asset Allocation using Economic Indicators

by Georg Vrba, P.E., 8/24/10

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Most long-term stock market investors follow a buy-and-hold strategy, one that makes big losses unavoidable when major downturns strike the stock market. This strategy assumes that an investor cannot know when to switch from one asset to another and that if one avoids the bad days of the market, one is also likely to miss the best days.

Buy-and-hold may have been a successful strategy during the bull market from 1980 to 2000, but it has been a disaster over the last 10 years. A $10,000  investment in the Vanguard S&P 500 Index Fund made 10 years ago (in August 2000) would now be worth only about $8,600.

Another standard piece of advice is to diversify one’s investments.  A recent article in Advisor Perspectives by David B. Loeper, Fake Diversification Exposed: Does Asset Allocation Work?, concludes that apart from a diversification into intermediate-term Treasury bonds, other “diversifiers” do little to protect one’s investments. Investors should sell or significantly reduce their stock holdings in anticipation of a recession or slowdown of the economy and switch into a Treasury bond fund, and then reverse the process ahead of a recovery.

The problem investors face is determining the timing of the switch.

I present a way to resolve this dilemma. My model is based on various economic indicators that provide timely buy and sell signals for the S&P 500 index.  Trading signals are generated when certain patterns of the decision variables occur that have historically always preceded a particular major change in market direction. It is reasonable to assume that similar patterns will occur in advance of future similar changes in market direction.

My model typically provides sell signals before contractions of the economy and buy signals when economic recovery is imminent, with all signals occurring well before the market has responded much to the perceived economic changes.  Acting on the model’s signals is instrumental to avoiding major market downturns while still being invested in the market at all other times. This timing approach, with funds placed into a money market account when they are not invested in the market, achieves excellent returns over long periods of time, as shown by the “Value” graphs in figure 1. Even better returns result if the investment is switched into a fund that invests in Government National Mortgage Association (GNMA) pass-through certificates, such as the Vanguard GNMA Fund, instead of a money market fund. The model is described in Appendix A.

There has recently been much speculation in the financial media whether the Economic Cycle Research Institute’s (ECRI) U.S. Weekly Leading Index (WLI) and the index's annualized growth rate are currently suggesting an upcoming recession. It is naive to suggest that just because the WLI growth rate has declined to a certain level that a recession is imminent. The present steepness of the yield curve — the forward rate ratio between the 2- and 10-year yields is at a record high of almost 1.20, an unprecedented level — does not support a recession prediction. As can be seen in figure 1, the yield curve has been inverted prior to the last seven recessions (indicated by the forward rate ratio between the 2- and 10-year yields being less than 1.00), but currently it is extremely steep. The growth rate of ECRI WLI has at the same time declined to a negative, recession-predicting level.  That has not happened in the last 45 years, and presumably that decline is why there is so much discussion about this in the financial media. The negative value of the WLI growth rate suggests that growth will be miserably slow. For a description of the forward rate ratio see Appendix A and B.

The more important question facing investors now, however, is to what extent one should be invested in the market. My model suggests that one should have significantly reduced one’s market exposure at the beginning of April 2010.  The model, which also relies largely on the WLI, provides the mathematically derived signals to reduce or sell one’s stock market investments well before recessions and economic slow-downs occur, generating sell signals near market tops and buy signals near market bottoms.

Appendix C lists all the trading signals from 1966 onwards that this model provided including a type C sell signal at the end of March 2010 and a type A sell signal near the end of April 2010.  The model provided a sell signal before the 1987 stock market crash, and also near the 2000 and 2007 market tops. It also generated buy signals in March 2003 and March 2009, near the market’s lows.

Figure 1 depicts the S&P 500 Index with the sorted trading signals from the model superimposed.  The “Value” graphs on this chart show the value over time of an initial investment based on the model’s trading signals. The investment, when out of the market (on the "Value" graphs, the smooth lines between sell and buy intervals) is assumed to earn interest at the prevailing Federal Funds Rate. The end value on 3/30/2010 for an investment made in 1966 is more than 15 times higher (a 13.31 % average annual return), and similarly an investment made in 1980 would be about seven times higher (a 15.38 % average annual return) than what the same investments would have grown to if left permanently in the market.  Dividend income is not included in the analysis.

An investment made on 7/3/80 in the Vanguard 500 Index Fund with dividends reinvested would have provided a 16.51 % average annual return if the trading model was followed, versus 9.81 % if the initial investment was left permanently in the fund. If the funds, when out of the market, were invested in the Vanguard GNMA Fund instead of a money market account, the investment would have provided a 17.58 % average annual return.