There are two good reasons to take a look this week at the most downloaded paper on the Social Science Research Network. For a start, we’re heading into Labor Day weekend, which means it’s time for light beach reading. Second, the paper is focused on a market-timing strategy, and this particular market timing strategy current suggests investors should proceed with utmost caution.
Here’s Mebane Faber, the paper’s author and co-founder of Cambria Investment Management, on Twitter on Tuesday:
In other words a portfolio based on the paper’s strategy would be fully invested in cash and bonds last month—no stocks. As Faber noted, that’s extremely rare, occurring less than 7 percent of the time. The potentially most worrisome bit is that the last time this happened was in the depths of the financial crisis.
Founded in the 1990s by two financial economists, the SSRN has quickly become a go-to website for a large number of people in the finance industry. The site’s concept is pretty simple: It allows authors to upload their academic papers directly to the site for free downloading worldwide, while publishers and institutions have the option of uploading papers and charging a fee for each download.
The most popular paper on the website is Faber’s “A Quantitative Approach to Tactical Asset Allocation.”
Originally published in 2006 and most recently updated in 2013, his paper has been downloaded more than 150,000 times on SSRN. It focuses on a market-timing technique to help investors smooth volatility in their portfolios while remaining in profitable positions—and protecting themselves should the bubble burst.
Here’s an illustration of the problem Faber is trying to solve.
While investing in any of these assets would have produced returns for investors for many years, it would also subject them to the risk of significant periodic “drawdowns” when prices drop suddenly from peaks:
Faber suggests a market-timing solution, or a “risk-reduction technique that signals when an investor should exit a risky asset class in favor of risk-free investments.” One particular brand of market timing he suggests works this way: Investors should buy when a security’s monthly price is higher than its 10-month simple moving average and sell when the price is less than the 10-month simple moving average.
You can see a comparison of this strategy vs. a buy-and-hold approach in the Standard & Poor’s 500-stock index below: