Friday, October 2, 2015

Using "Normal" Drawdowns as a Timing Signal

The below analysis was purely an accident. I was actually looking into periods the U.S. stock market "suffered" a 10% drawdown for the absolute opposite reason; to show that a buy and hold investor should likely ignore these regularly occurring events. How regular?

The always interesting Ryan Detrick points out:

I looked at every calendar year since 1960 and looked at various correction levels. Turns out 94% of all calendar years see at least a 5% correction, while 53% of all years see a 10% correction. Maybe this recent 12% correction isn’t so alarming?
So... what if an investor were to sell-out of their U.S. stock allocation and shift it into bonds whenever one of these standard 10% drawdowns occurred and were only willing to go back into stocks when they once again were within 10% of its all-time high?

  • At month-end if the drawdown from its previous peak was less than -10%, bonds (US Agg)
  • Otherwise, stocks (S&P 500)

Well going back to 1976 (the inception of the Barclays U.S. Agg bond index), the results were surprising. Almost 100% of the return, about 20% less volatility, and less than half of the drawdown. As interesting is how well it kept up with the stock market in all periods except those that followed severe drawdowns. This is largely due to the rarity of which 10% drawdowns become 30, 40, or even 50% drawdowns, so the strategy was at most times fully invested.