Investment Math

In the 2008-2009 bear market, all investment asset classes suffered significantly drawdown at the same time. In this global economy, investment bubbles are inflated and deflated at much faster pace and different asset classes become more correlated with each other, making it difficult to spread or reduce risk through allocation or diversification. Is any objective alternative to traditional buy-and-hold asset allocation/diversification scheme for the investors to reduce the pain during the bust cycle while participating the boom cycle when growth returns?

The 2006 paper “A Quantitative Approach to Tactical Asset Allocation” by Mebane T. Faber proposed a simple, price-only, non-optimized, yet elegant solution to above problem, and it proves to work beautifully in out-of-sample 2008-2009 bear market. Readers can use google to find the latest paper which is updated to include more out-of-sample results.

In previous post, it is shown the clear superiority of ^VAY index over any style, sector, country, or asset class. But like all other investment instruments, it suffered 60% drawdown during the 2008-2009 period, which is very difficult for any investor to swallow not to make emotional decision to give up long-term investment goal.

In this post, Faber’s approach is applied to the ^VAY index to see if drawdown can be reduced without hurting performance. Figure 1 shows the exact buy/sell points for ^VAY based on the Faber’s 10-month moving average technique.

Figure 1 shows that one would get out ^VAY at the beginning of August 2008 and re-enter the market at the beginning of May 2009. It clearly avoids the largest drawdown period of the bear market and captures a substantial portion of the initial bull market, just like it did in 2002 bear market.

However, there are numerous false signals creating unwanted whipsaws before both bear markets, making the technique difficult for less experienced investors to follow. Whipsaws from false signals are typical of price and volume-based technical analysis, since human fear and greed from reading news or rumors creates short-term irrational price and volume trading patterns that can’t be explained by mathematical formula (and are frequently taken advantage of by professional traders.) One simple way to avoid the whipsaws is to apply Faber’s technology to fundamental earning data, which is the true representation of the strength of the underlining market. Since there is no publicly available historical ^VAY earning data, Figure 2 shows the result of applying Faber’s 10-month moving average technique to historical SP500 earning (due to availability of data, quarter earning is used in 2000).

Comparing with Figure 1, Figure 2 clearly shows the whipsaws are greatly reduced since earning data shows steady deterioration months before crashes. Although SP500 earning is not necessary a good approximation to ^VAY earning, it serves the purpose of this post to explain the concept. To obtain better buy/sell points, it is possible to calculate the actual composite ^VAY earning from all companies in ^VAY index.

Figure 3 below compares the performance of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). After a sell signal and before a buy signal, the performance is calculated using cash without any interest. As expected, the performance of price-based timing technique suffers due to whipsaw during normal bull market, but is compensated during severe bear market. Earning-based timing technique outperforms the ^VAY by closely following the performance of ^VAY during bull market while avoiding most of drawdown during bear market.

Figure 4 compares the drawdown of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). Both timing techniques maintain the same drawdown size during bull market, but significantly reduces the drawdown during bear market.

In summary, the key to long-term investing success is to have an objective and unemotional strategy to reduce drawdown during bear market while participating the growth in bull market. The goal can be achieved by applying Faber’s technique to earning data of the underlining market to reduce bear market drawdown significantly without giving up the performance of bull market. Of course, stock market is very dynamic and dangerous, there is no guarantee that the experience learned from previous bear markets can be successfully applied into future.