March 20, 2012
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Back-tested results often look good on paper because stellar performance could have come from curve-fitting. If that were the case, then my "Holy Grail" model would not have withstood the test of time. But in the 32 months that have passed since its publication, investors who heeded its advice would have outperformed the market on a risk-adjusted basis.
I presented my Holy Grail model in a three-part series entitled Moving Average - Holy Grail or Fairy Tale (Part 1, Part 2, and Part 3) nearly three years ago. Let’s review the rationale behind my methodology, how the Holy Grail works and the out-of-sample results since its publication.
The Holy Grail is not market timing
Academically cited, empirical evidence has traditionally favored buy-and-hold over active or tactical investment strategies. That evidence shows that no one beats the market in the long run. But this conclusion is only correct if “the long run” means from the 1940s to the 1990s, the period over which most of this research was conducted.
The problem is that this conclusion was biased by the highly skewed data. This period encompassed two spectacular bull cycles (1940 to 1966 and 1982 to 1999). A more appropriate conclusion would have been, "buy-and-hold works in bull markets." The “Holy Grail” method captures as much of the bull markets as possible, while avoiding the worst of bear-market cycles. As a result, it outperforms buy-and-hold on a risk-adjusted-return basis in both bull and bear markets.
Market timing is generally misconstrued as synonymous with forecasting market turning points. By this definition, I am not a "market timer." I cannot anticipate market turning points in advance. My notion of market timing is similar to atmospheric monitoring. We do not need to forecast the weather in advance, but we must be observant of ever-changing weather patterns and be ready to act accordingly. To detect and track weather changes, meteorologists use temperature gauges, barometers, and computer models. To monitor investment climate, I use market-timing models.
As a technical timing model, my Holy Grail model does not offer predictions. It follows price trends. In future articles, I will present other types of timing models that are driven by fundamental, macroeconomic, cyclical, and seasonal factors. These environmental gauges enable one to better assess the investment climate.
How the Holy Grail model works
My Holy Grail model is a six-month exponential moving-average crossover (EMAC) system. I use Professor Robert Shiller’s S&P 500 data series as the signal generator, because it has a long history dating back to 1871 and because it is accessible to the public. My Holy Grail model turns bullish when the Shiller S&P 500 crosses above its six-month EMA and bearish when it crosses below. When the model turns positive, one invests in the S&P 500 total-return index and collects dividends; when it turns negative, one sells the S&P 500 and puts the proceeds in cash. For a detailed description of my model, please refer to the three-part series to which I linked in the introduction.
It is not my intention to promote the Holy Grail as a trading tool; past performance cannot be assumed to prevail in the future. The Holy Grail is used as a counterexample, to disprove the claim that buy-and-hold is the only logical investment strategy. Holy Grail proves that one can beat the market by following trends, not by predicting market turning points.
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