Opinion – Grain in Grain: They tested dozens of strategies to predict the market; check the result

Anticipating market movements is possibly the hardest way to consistently make money on the stock market. For this reason, it is a strategy with great potential to generate results for the investor. But also value destruction when poorly implemented. It is no wonder that it is proven that the vast majority who try to do it are not successful.

The idea behind this strategy known as market timing it’s relatively simple. You should use signals and rules to avoid market dips and capture positive reversals. Thus, it can improve the performance with respect to the well-known strategy of buy and hold (buy and keep).

That being said, it seems that it is easy, but researchers lean in front of machines for long periods testing different strategies in search of one that presents a robust result.

This is one of the research challenges of asset manager DAO Capital. I worked with one of the partners for almost a decade, the PhD in economics from the Leuven University of Belgium, Marco Lyrio. So I know the depth of their work well and I visited them last Monday to discuss market and strategies.

The DAO fund has appreciated 12.5% ​​since its inception in March 2021, against a -8.8% devaluation of the Ibovespa in the same period.

DAO Capital studies the implementation of this type of strategy systematically. To better understand the potential of this strategy, this time I interviewed another DAO partner, Caio Castro, responsible for this research in market timing.

According to the “thermometer” they built to forecast the market, the timing suggests caution. But companies that fit the value and quality factors should stand out.

Below I transcribe part of the interview.

Many investors believe they can make money by trying to anticipate stock market movements. Do you believe this is possible?

Initially, let’s talk about what we know for developed markets. Neuhierl and Schlusche (2011, JFEcts) carried out a comprehensive study where approximately 7000 rules for market timing were tested. Several of these rules have shown superior performance to the simple buy and hold strategy. However, the authors draw attention to the possible presence of data snooping (choosing data that, a priori, overestimate the capacity of the model), which casts doubt on how many rules, effectively, are good instruments to anticipate the direction of the model. Marketplace.

For the Brazilian market, the challenges are much greater. First, because the research on the subject is more limited, when compared to the American market, for example. In addition, the Brazilian market has very high volatility levels and a relatively short history (ideally, at least 50 years of market data), which makes it very difficult to research and identify robust signals that anticipate the direction of the local market. .

But to answer your question, yes, we know the difficulties and are well on the way to developing a signal that can complement our current investment strategy.

What are the risks of this strategy of trying to anticipate market movements?

The main risk of this type of strategy is that you bet the chips exactly in the opposite direction of the market, significantly increasing the losses and risk of the investment.

In general, market timing strategies work well to make smooth and small moves within a broader strategy used for the composition of the portfolio as a whole. Going too strongly in the direction of the market can be disastrous for an investor’s portfolio.

This type of strategy requires extra attention to manage risks, volatility, correlation, position size, leverage, among other variables. Choosing the right instruments (stocks, options, futures contracts, etc.) is also critical. It is not enough to anticipate market movements, you need to have exposure to the right instruments to capture those movements. And, of course, a lot of agility to change your opinion if the market direction is not confirmed.

You studied various strategies. Which are the worst?

It would be difficult to list the worst ones, because every strategy that doesn’t work is bad in its own way. But the investor cannot depend on obvious signals. Metrics of inflation, GDP, employment are very good at explaining the past, but they do not work to guide a market timing strategy. They do not work in Brazil and in any of the countries we researched. Likewise, trend signals are not suitable for identifying market reversal moments.

Did you find any strategy that stands out in Brazil? What does it signal?

In Brazil, there are few signs that have any predictive power over market cycles. One is what we present in more detail on our blog, which is our proprietary way of analyzing average market returns versus average fixed income returns.

The idea was to build a “thermometer” for the attractiveness of the Brazilian market, given the cost of capital allocation for investors and companies. Needless to say, with the significant increase in interest rates in Brazil in recent months – which has not been accompanied to the same extent by an improvement in corporate fundamentals, on average – the signal is now marginally pessimistic with the direction of the Brazilian market.

Can we talk about the probability or success rate of this strategy?

A lot depends on the signal and investment horizon. Our best signal is calibrated to measure large changes in market cycles over the long term. On 3-year moving windows, the sign usually points in the right direction in 70% of the situations. For daily or even weekly windows, the result is irrelevant.

Due to the reduced number of datapoints for the Brazilian market, even the hit rate is a relatively uncertain number. Anything above 60% is usually pretty good.

How would it compare to you simply staying long, the so-called Buy and Hold?

Our market timing signal added a 2% return per year and reduced the size of the biggest declines in a buy and hold portfolio by 50%, from 2007 to 2021. the market direction layer had a 38% better return/risk ratio than the traditional buy and hold portfolio.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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