Otar's "storm warning" approach

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markierussell
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Otar's "storm warning" approach

Post by markierussell » Tue Aug 09, 2011 12:37 am

I raised this in another string but I'm inviting broader comment as it seems very timely.

Jim Otar, whose book has received a lot of favourable comment on this site, advocates an equity investment approach for turbulent times using moving averages: when the 5 month moving average goes below the 12 month moving average, he considers it a "storm warning" and suggests reducing equity exposure. Then wait until the 5 month average goes above the 12 month, and that is a sign the storm is likely over. That's when to increase equity exposure.

Given the recent slump, we are in a "storm warning" scenario. So this theory would say do not buy equities until the 5 month average moves above the 12 month.

It seems this approach flies in the face of the standard "don't time the markets" Bogleheads approach but if you look at the historical lines it looks persuasive. Comments?
Last edited by markierussell on Tue Aug 09, 2011 11:44 pm, edited 1 time in total.

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Post by MWCA » Tue Aug 09, 2011 12:48 am

If there was a sure fire way to market time accurately. It would have been found out by now.
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Post by markierussell » Tue Aug 09, 2011 1:15 am

MWCA wrote:If there was a sure fire way to market time accurately. It would have been found out by now.
To be fair to Otar, he doesn't say his method is sure-fire. He says it is a way to decrease the likelihood of investing on the verge of a strong downturn and to increase the likelihood of better long term returns. The important question is not whether it is sure-fire but whether it has sufficient merit that we should use it to depart from a typical buy and hold or dollar-cost averaging approach in times like these.

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Post by DartThrower » Tue Aug 09, 2011 11:37 am

OK let's say it is not sure-fire but it is a "valid" way to time the market in the sense that it can be used on a longer term basis to beat a passive strategy. If that were the case, wouldn't some mutual funds or hedge funds adopt this method and beat their competitors with some degree of consistency? I haven't heard of any research that points to evidence of this consistency in out performance, especially after taking expenses into account.

If anyone can find some studies showing this out performance I would be interested in seeing them.
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Post by Stonebr » Tue Aug 09, 2011 1:04 pm

DartThrower wrote:

If anyone can find some studies showing this out performance I would be interested in seeing them.
As I recall, Otar isn't necessarily claiming out-performance. He's only claiming that if the market drops 90% (like it did in the early 30s), you won't have to eat catfood or move in with the relatives in your retirement. He's more interested in portfolio survival in worst case scenarios than out-performance. That said, I think this is the weakest part of his book and I ignored it, since the easy alternative would be to simply change your permanent AA to something with less equities.
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Post by rwwoods » Tue Aug 09, 2011 1:10 pm

I would call it a risk reduction strategy. Another risk reduction strategy is to use a form of the 200 day moving average. Does it beat buy and hold? Sometimes yes and sometimes no, but that is not the purpose. The purpose is to reduce risk.
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Post by ladders11 » Tue Aug 09, 2011 2:18 pm

The problem with these strategies is that their historical success relies on the fact that they have been out of the market on the worst days. If you see the worst days as independent events then the strategies are spurious.

Consider the example of the crash of 1987. The market was below the 200-day moving average. Did the factors that forced the market below the 200 DMA cause or contribute to the crash? I don't know; but, your answer to that question should inform your interest in trend following with the 200 DMA.

If there were a few stock market crashes while the markets were above their 200 DMA, nobody would be talking up this strategy, because results would have been worse than staying fully invested. If you believe that the market could crash anytime for any number of randomly-timed reasons, the best strategy is to stay invested at your risk tolerance. IMO crashes are caused by computer glitches, terrorists, accidents, and other truly random events that don't follow from recent trends.

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Post by walkinwood » Tue Aug 09, 2011 8:39 pm

Are there any studies on the risk reduction of the 200 day avg strategy over long periods - say 30 years? It certainly looks compelling when viewing it on a graph.

What metrics of risk would you use? Lower volatility while losing only a small percentage of cumulative gain would be a good metric.

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Post by Bongleur » Tue Aug 09, 2011 9:47 pm

Except that the 200 dma is now being front-runned by traders... it doesn't work as well or at least the same, as when it was first "discovered."
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Post by markierussell » Tue Aug 09, 2011 10:44 pm

Stonebr wrote:
DartThrower wrote:

If anyone can find some studies showing this out performance I would be interested in seeing them.
As I recall, Otar isn't necessarily claiming out-performance. He's only claiming that if the market drops 90% (like it did in the early 30s), you won't have to eat catfood or move in with the relatives in your retirement. He's more interested in portfolio survival in worst case scenarios than out-performance. That said, I think this is the weakest part of his book and I ignored it, since the easy alternative would be to simply change your permanent AA to something with less equities.
I agree with the first part of Stonebar's comment. Otar is not recommending his strategy to fund managers, because it is not intended to beat the market. It is intended to prevent catastrophic loss. Especially in the distribution (retirement) phase, his view is that if your portfolio is sufficient for your needs (in the "green zone") then you don't have to beat the market or even match the market, what you have to do is avoid a big loss, especially early in retirement. So yes, it is a defensive strategy and wouldn't help fund managers earn performance fees. As for Stonebar's suggestion that you could permanently reduce your exposure to equities instead, I don't quite see how that works, because if, say, your optimal equity allocation is 40%, then if you reduced it to say 20% when markets started to turn down (e. g. the 5 day moving average feel below the 12 month) and kept it there permanently, say through a 10 year bull market, would you not suffer an unnecessary reduction of return? Why not just reduce your exposure during the downturn and then beef it up afterward, as Otar suggests?

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Sam2
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Post by Sam2 » Tue Aug 09, 2011 11:19 pm

Correction. Otar is comparing 5 months moving average not 5 day.

Sam

markierussell
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Post by markierussell » Tue Aug 09, 2011 11:41 pm

Sam2 wrote:Correction. Otar is comparing 5 months moving average not 5 day.

Sam
Sam, thank you, you're right. He plots 5 months (not days) against 12 months. I think the principle and analysis remain the same, though.

Incidentally, does anyone know a free website that offers easy charting of the 5 month and 12 month moving averages? The closest on Yahoo seems to be 20 day/200 day.

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Re: Otar's "storm warning" approach

Post by grayfox » Wed Aug 10, 2011 2:44 am

markierussell wrote:I raised this in another string but I'm inviting broader comment as it seems very timely.

Jim Otar, whose book has received a lot of favourable comment on this site, advocates an equity investment approach for turbulent times using moving averages: when the 5 month moving average goes below the 12 month moving average, he considers it a "storm warning" and suggests reducing equity exposure. Then wait until the 5 month average goes above the 12 month, and that is a sign the storm is likely over. That's when to increase equity exposure.

Given the recent slump, we are in a "storm warning" scenario. So this theory would say do not buy equities until the 5 month average moves above the 12 month.

It seems this approach flies in the face of the standard "don't time the markets" Bogleheads approach but if you look at the historical lines it looks persuasive. Comments?
This sounds like a form of "portfolio insurance".

The canonical Boglehead philosophy is Constant Mix which requires rebalancing, which has you buying stocks when they fall and selling stocks when they rise. This is a concave strategy, and does best if there are reversals and mean reversion.

But there is an opposite strategy called Constant Proportion, or Constant Proportion Portfolio Insurance (CPPI), which has you selling stocks when they fall and buying stocks when they rise. This is a convex strategy, and tends to do best if the market trends up or down and few reversals.

You can also do nothing when stocks prices rise or fall, which is Buy & Hold.

None of these is optimal under all circumstances. It depends what the market does. Which strategy you choose depends on your risk preferences.

Alternatives to Rebalancing
Last edited by grayfox on Wed Aug 10, 2011 7:17 am, edited 1 time in total.

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Post by nisiprius » Wed Aug 10, 2011 6:09 am

Haven't tried to analyze or backtest or looked at Otar's approach. I'm afraid reading is book is still in my "to-do" list. But the following thought occurred to me.

Maybe the goal should be constant risk.

Let's define "tactical asset allocation" to mean changing stock allocation according to a simple, mechanistic rule based only on well-known pieces of published data.

You can always get more risk with more return and vice versa, since you can increase both risk and return by leveraging and reduce both by dilution (reducing allocation to the risky asset). I will flatly use the word "impossible" and say I think it's impossible to improve risk-adjusted return by using tactical asset allocation.

What seems possible to me, though, is "risk smoothing." It certainly might be possible to detect that the stock market is riskier at some times than others, and one might be able to adjust asset allocation for constant risk.

Imagine that one has a perfectly constant "risk tolerance" that must never be exceeded. The conservative investor such as myself tries to choose a stock allocation that never exceeds my risk tolerance even at the worst times. That might mean that during calm periods my allocation is safer than it needs to be and therefore returns less than it might.

It might be possible to obtain a higher return by gain-riding risk, amping up risk during calm periods and dialing it back during stormier ones.

I've lost count of the number of "ifs" here, but this is a mental framework that allows for the possibility that a shifting asset allocation could be beneficial to the investor even without improving risk-adjusted return.
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Post by Bongleur » Wed Aug 10, 2011 6:49 am

Proponents of the Permanent Portfolio would say that it is the "smoothest" available...
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Post by grayfox » Wed Aug 10, 2011 7:16 am

nisiprius wrote: It might be possible to obtain a higher return by gain-riding risk, amping up risk during calm periods and dialing it back during stormier ones.
Well one popular measure of risk is the VIX which is the Chicago Board Options Exchange Market Volatility Index. I forget exactly how it works, but it somehow measures implied volatilty of the S&P 500. I think using options prices or something like that.

http://finance.yahoo.com/q/bc?s=%5EVIX& ... z=l&q=l&c=

So maybe you are suggestion adjusting the amount in stocks somehow with the VIX. MEAN(VIX) looks about 15 or 20. So to hold risk constant,

VIX > MEAN(VIX), reduce stock allocation.
VIX < MEAN(VIX), increase stock allocation.

Yesterday, VIX just shot up to 47 at 2:30pm when the market tanked then fell to 35 at the 4pm close bell.

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Post by SVariance1 » Wed Aug 10, 2011 8:04 am

I am not suggesting that people try to "time" the market but IMO, there are better ways to do it. This smells like momentum to me. If one wants to "time" the market, he or she would be much better off focusing on valuations. We all know this but it is better to buy low and sell high.
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Post by Trader007 » Wed Aug 10, 2011 8:17 am

On the recent down move we have bounced from 200 daily, weekly and yesterday monthly. Of course when enough people are using it some will try to take advantage of them. And if the market moves sideways for a longer period it´s not that great i guess.

support/resistance is the best because that is the DNA of the market.
There are psychological ones that everyone can see and then those based on volume.

Or even more "simple". Every large up and down move since year 2000 have been around 50 and 100%. S&P500 went down 57% from 2007 and now it turned down after 105% up since March 09.

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Post by nisiprius » Wed Aug 10, 2011 8:44 am

grayfox wrote:
nisiprius wrote: It might be possible to obtain a higher return by gain-riding risk, amping up risk during calm periods and dialing it back during stormier ones.
Well one popular measure of risk is the VIX which is the Chicago Board Options Exchange Market Volatility Index. I forget exactly how it works, but it somehow measures implied volatilty of the S&P 500. I think using options prices or something like that.

http://finance.yahoo.com/q/bc?s=%5EVIX& ... z=l&q=l&c=

So maybe you are suggestion adjusting the amount in stocks somehow with the VIX. MEAN(VIX) looks about 15 or 20. So to hold risk constant,

VIX > MEAN(VIX), reduce stock allocation.
VIX < MEAN(VIX), increase stock allocation.

Yesterday, VIX just shot up to 47 at 2:30pm when the market tanked then fell to 35 at the 4pm close bell.
I'm not suggesting any methodology and I'm not going to try to invent one. I'm just opening my mind to the possibility that there could be rationale for some kind of tactical asset allocation that does not violate my pigheaded belief that it can't increase risk-adjusted return. Personally, I'm content with the simplistic method of keeping my stock allocation low enough to live with at all times, and if that means there are times when it is safer than it needs to be I'm OK with that.

There has to be some predictive aspect, I think, because by the time the risk is visibly manifesting itself, it's too late to pull back.
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