Market Timing versus Holding Bonds

Research
1

There’s been a lot of discussion about market timing and hedging to reduce risk. I won’t rehash all of the points, but generally agree with Marc Gerstein’s views, as I am skeptical that market timing rules will be effective out-of-sample.

It seems that the average retail investor is looking for performance similar to a hedge fund, or at least what most hedge funds are attempting to achieve, which is equity-like returns with bond-like risk. Many of the better models that I have developed (and seen in P123) can achieve high returns, but with either higher risk or similar risk to equity indexes. While market timing works well in backtests, in my opinion, the best tool for reducing risk is good ol’ fashioned diversification, namely using a healthy dose of fixed income.

As you can see in Chart 1 below, a model with high returns may also have unacceptable risk for most retail investors. But, if an investor wanted to target <10% maximum draw downs, they could simply hold 80% in a bond ETF, and still achieve much higher returns than an equity index (at least for this simulation), as shown in the book simulation in Chart 2.

Holding a fixed allocation in bonds to reduce risk is: (1) transparent; (2) based on sound financial theory, as bonds have relatively low correlations with equities; and (3) very straightforward to implement and understand with no leverage, shorting or derivatives.

It may be helpful to allow book simulations for R2G models that hold a fixed allocation to bonds or other asset classes to reduce risk. It may also be useful to allow for spliced benchmarks, to reflect a multi-asset class benchmark that may include both equity and fixed income.

Any thoughts?

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2

Quad - what bond fund would you propose? Most consider bonds to be in a bubble and will implode sometime in the future. If it is Tbills or very low interest rate, it will be more conservative but you may get killed by the rebalancing costs. How frequently is the book rebalanced?

Steve

3

Hi Alan,

I’m with you on this one. I tested various allocations of stocks and bonds across various countries such as the US, Asutralia etc for as many years as I was able to get data for using ten year government bonds of that same country. For example when I tested Australia I tested a range of fixed allocations to the Australian stock index and Australian Gov’t bonds. The minimum best allocation for this test was at least 15% - 20%.

Despite the low interest rates on government bonds don’t overlook it’s benefits for diversification. If you are worried about interest rates going up then you can invest in a system that switches between bonds like my “The Bond Hedge”. It improves returns and risk at the expense of volatility. Meaning that it has lower risk because it won’t be a sitting duck during times when interest rates trend upwards but will switch to a better trending bond class. It will switch back once a trend of money flowing in to government bonds develops. It has higher volatility because trends take time to develop and when a trend first begins to form it may be riding a bond category down until the new trend is detected.

I like the idea of spliced benchmarks (i.e. 60% stocks / 40% bonds or 25% stocks, 25% bonds, 25% cash, and 25% gold).

4

But then this is swapping out a stock timing system for a bond timing system :slight_smile: There is no guarantee that it will work.
Steve

5

Don’t worry guys, after the next major crash we’ll have a better idea of what works and what doesn’t.

6

Yeah - we just have to ask the guys who are still solvent!
Steve

7

[quote]

But then this is swapping out a stock timing system for a bond timing system :slight_smile: There is no guarantee that it will work.
Steve
[/quote]Steve the maximum volatility of a bond ETF is almost always much better than the stock market. Therefore the worst case scenario for a combination 80% stocks and 20% The Bond Hedge is still better than the worst case scenario of a stock timing system. Even “risky” bonds are less risky than stocks.

Furthermore, the weakness of market timing based system based on market trends (such as moving averages) is not that they don’t detect downturns. Trend based market timing usually do detect almost all bear markets during the early stages when drawdowns are still reasonable. This has been Denny’s investing experience and is consistent with my backtests on many stock markets over many decades. (The exception might be a very sudden 1987 style bear market that it might miss, but that type of sudden bear market has been extremely rare historically). Therefore during real bear markets most trend based timing should reduce drawdowns. This mechanism to reduce drawdowns is true both for stock based timing systems and also for The Bond Hedge.

The big weakness of a trend based market timing system is that it will have a lot of times when the timing system will go to cash because of a brief correction–just in time to miss the bounce back. This is a known risk that is taken by these systems and is known as whipsaws. It means that trend based timing that goes to cash will lag the market by a lot–perhaps even losing money–during bull market corrections. (See Denny’s R2G systems).

The Bond Hedge does not get hurt by whipsaws nearly as much as a stock timing system based in trends mostly because the stock portion of your portfolio stays invested. This picks up the slack from the bond portion during the bounce. Secondly, since bonds generally have lower volatility than stocks the overall volatility of a portfolio which is Stocks + The Bond Hedge is better even when it misses some signals. Furthermore, the biggest risk to your overall portfolio from using The Bond Hedge is that it may be in junk bonds when the market goes down and will stay there as the market crashes. This risk is very low because trend based systems do tend to exit the markets before a trickle turns into a flood; before the correction turns into a bear market.

8

Chipper - I hope the bond market behaves in the future as you describe. An alternate view is that once the bond market bursts, it will be a huge sinkhole for a long time to come, perhaps a decade or more. The stock market may not be going up while you are trying to fill the sinkhole.

Steve

9

Steve,

Actually, interest rates on ten year U.S. Treasuries have gone up before; from 8% in 1962 (the first year that I have daily data) to a peak of 16% in 1981. This “big sinkhole” that you are so worried about was up over 100% during this time of rising interest rates. The Bond Hedge would most likely have made much more that staying in ten year US Treasuries at the cost of slightly higher drawdowns.

EDIT:
The first chart compares the performance of ten year Treasuries to the stock market during a rising rate period.
The second chart is a portfolio which is 50% in ten year Treasuries and 50% in the S&P 500 stock index rebalanced monthly.

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10

Chipper - what bonds were used in the second graph? Physically holding bonds to maturity is different than the bond ETFs we have today.
Steve

11

The second graph is 50% ten year U.S. treasuries index and 50% S&P 500 Index rebalanced monthly.

12

@Stittsville123

I would suggest using an ETF that tracks the Barclays Aggregate Bond Index, such as AGG or BND. In my original post, I used IEF as a proxy, since neither the AGG nor BND have history back to 1999.

I don’t know if bonds are in a bubble, nor do I know when rates will start to increase, or how far rates will increase. I do know that bonds nearly always perform well during large equity market draw downs.

That being said, bonds have been in a secular bull market for several decades now due to declining rates, as shown in the first chart below, which may be ending. But while the second chart shows that one-year bond performance can be negative as rates increase, it is not a foregone conclusion. The third chart shows that over five years, which is the approximate current duration of the Barclays Aggregate, performance has still been positive even when rates increased significantly.

Another benefit of using bonds, is that it may allow R2G investors to customize the risk profile of a model, depending on their own preferences. For example, a model can be shown with varying allocations to fixed income, and investors can then weigh the tradeoffs in risk versus return.

@Chipper6

While I agree that bonds can be beneficial to reduce risk, my suggestion is to hold a constant fixed allocation, as opposed to market timing with a bond hedge. Hedging uses leverage, which I believe is unnecessary. I am also skeptical that market timing can be effective out-of-sample.

For example, a stock portfolio with 20 holdings and approximately one-month average holding period would be making about 240 independent “bets” each year. Multiplied by 15 years of history, I would have a sample size of several thousand trades to evaluate an investment model. This assumes that the simulation focuses on the signals generated from the ranking system, and includes no market timing, hedging or other “complex” options like stop-losses.

In contrast, we have probably three “events” to evaluate market timing models since 1999. I would personally need a much higher number of examples to gain confidence that the model will work going forward. I am hoping that the longer history from the Macro Charts may be useful, but we will see.

Lastly, even if a market timing model does find a good signal through the noise, no system works 100% of the time. It would only probably take one false signal (e.g., failing to identify a market crash, incorrectly signaling a market crash) to cause most investors to abandon the system.

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13

Quadz,

The Bond Hedge uses absolutely no leverage. I use it with a fixed allocation and no timing.

14

@Chipper6

I misunderstood, since I thought the word “hedge” implies the use of leverage or margin. But, there is still some element of market timing, as the model switches to Treasuries in a “risk off” environment. How can it know for sure when the environment will be conducive to risky assets?

I would probably put equities and some of these bond strategies (e.g., high-yield, emerging market debt) in the same “return-seeking” bucket. In contrast, I think of Treasuries as hedging or risk reducing.

15

Alan,

AGG is a fine strategy with low volatility and if it works for you that is fine. But the 2.3% yield of AGG is the maximum one can expect to earn from it. It is a big price to pay for the lower volatility. AGG doesn’t even go up too much when the market goes down. Government bonds are a better hedge but are earning even less. I figure that I can do better elsewhere.

Because The Bond Hedge uses a momentum based system, anytime a bear market takes more than three months to fall from it’s peak The Bond Hedge will detect it and reduce risk. The only time that The Bond Hedge will miss a bear market altogether is if a bear market will fall by twenty percent within a few months or less which will not give the system enough time to detect a trend. This has only happened once since 1927. Even if it does happen again the system my already be in treasuries before it happens.

Over an investing lifetime The Bond Hedge should make much more money that allocating some of your portfolio to AGG and with much lower risk than the 100% stocks.

16

I’ve actually got an R2G model which uses TLT as a partial hedge. It does quite well historically. https://www.portfolio123.com/app/r2g/summary/1159153

I was really just noting the irony of replacing one timing system for another. The rest is just pulling Chipper’s leg, which is a fun pasttime.

Steve

17

@Chipper6

My original post suggested combining two portfolios in a book with fixed proportions: (1) a bottoms-up stock-selection strategy (not an ETF strategy); and (2) a single bond ETF. For example, a book can include 40% in AGG, and 60% in the “S&P 500 Gems” R2G model, rebalanced weekly. This should reduce the maximum drawdown and volatility to levels that may be more appealing to at least some investors.

While AGG has a lower yield and expected return, its purpose is not to seek returns, but to reduce risk.

The “Bond Hedge” R2G strategy is a much different approach than what I was suggesting.

18

I don’t see holding a bond fund as having the “safety” of holding bonds. The safety of a bond comes from it having a fixed maturity value. A bond fund doesn’t have that. The ONLY value of the bond fund is the present value of all the bonds it holds. As interest rates change, that will change. There’s never a fixed value for you to exit at.

IMO, any testing history of bond funds on P123 is relatively bogus, because we haven’t really seen that much variation in rates. It’s pretty much been just trending in one direction. So it LOOKS like a safe haven.

But I don’t do much with bonds at all, so…

19

Hi Randy,

In case you missed it, I posted a chart of the US Treasuries from 1962 - 1982 when interest rates went up. You can see it here. Compared to stocks, bond funds are a walk in the park.

See also this chart from Pragmatic Capitalist:

[quote]
There have been some ugly experiences for investors in the US treasury market over this period. For example, in 1980 10-year yields rose from 9% to 14%. Investors lost 16% of their capital. But this worst annual drawdown in treasuries wouldn’t even make the top ten for global equities. Equity investors lost 48% of their money in the 2008 drop and 33% in the 2002 correction. Even last year’s [2012] drawdown (-11% loss), which was seen as relatively mild, would rank as the fifth worst in 40 years of US treasury market performance.

Overall, the worst ten drawdowns in global equities average 27%. That’s way more than the 11% seen in US treasuries. Even in notorious years such as the bond selloff in 1994, losses for treasury investors were unexceptional (-12%) compared with those regularly experienced in global equity markets.”
[/quote] - Pragmatic Capitalist .

20

Chipper - don’t sweat it. I for one will chip in to help keep you afloat when things get rough :slight_smile:
Steve

** Edit ** I found one guy on the net who is so sold on S&P 500 / TLT combination that he is selling puts on both. Apparently he wants to eat his cake.