Passive Investing 2.0
Timing the market is often seen as taboo but its less of a shot in the dark than you may believe
Passive investing has been growing recently. Growing may even be a bit of an understatement; more like exploding. According to MorningStar, the percent of US assets under management in passive equity funds has grown from 20% in 2007 to over 45% in 2018. In case you’re not too familiar with the investing world, that a lot of money — like 13 zeros a lot of money (trillions in case you were trying to count). It’s been popularized as an extremely viable investment strategy with low management fees, low volatility, and high return. The thought is that is since the market has trended upward to the tune of 6% for the past 100 years (or 10% if we include reinvested dividends), it will likely continue to do so for the foreseeable future. These numbers rise to 8% and 11% respectively if we just look at the last 35 years. Why bother with the risk and time associated with trying to marginally beat the market if the market is already producing lucrative returns with relatively low long run risk?
And I think this is a fantastic investment approach for the vast majority of individual investors. Most people do not have a degree in finance and do not have the assets nor time to justify a different investing approach. However this strategy still leaves a huge amount of investors, like myself, with the drive and mostly blind confidence that it must be possible to significantly beat the return of a broad index of the 500 largest companies. Typically this is pursued by either personally creating a diverse portfolio of promising investments or maybe just investing in index funds tracking more specific industries like tech or healthcare. With this article though, I want to make the case for a third investing strategy for beating the market as an individual investor. And it’s an extremely simple one. Like a trade only one every few years kind of simple.
My proposed strategy is not a new one and it is a far cry from a get-rich-quick scheme. More simply it is a marginal improvement on the passive investing strategy already pursued by some but rarely pursued in a similar way to what I propose. I am talking about applying the strategies of technical analysis, valuation and statistics typically reserved for active investors to macroeconomic indicators in a more Soros-ian approach to improve passive investing return. Put more simply: buying and selling a broad market index fund around recessions. A sort of active, passive investing approach. Now before you close the browser thinking that is a basic goal that every investor already tries to accomplish, hear me out. I am not talking about the basics. I am talking about rather than investing the tens of hours a week in consuming individual company, sector, and broad economic news, investing a fraction of that time in building macroeconomic models to decide on the rare entry and exit points. I want to present a case for an active passive investing style as an extremely viable investment strategy in terms of a return to time invested ratio. Even more so than simply passive investing. Now let me barrage you with some numbers then I’ll get into the more speculative aspects of how this could realistically be done.
If we look at the past two bull markets, an S&P index fund would return about 16% with reinvested dividends. If we look one past that at the bull market that ended in the .com bust, the return was about 20.5%. If you were to invest only during bull markets and keep your investments in a money market fund in between, you could have achieved an average of a bit over 16% for the past 28 years (starting in the bull market of ’91-’00). That 5% premium is a big deal; the final value of the investment over those 28 years would be 3.5 times that achieved through just passive investment. Now this is assuming we can predict the recession relatively precisely. Of course this is impossible. But we may be able to get close assuming the world economic system doesn’t drastically change. Despite my lack of an economics degree, I would argue that we have seen relatively strong macroeconomic predictors for past recessions. Now there is an inherent risk for these indicators to fail in the future but if that were to happen, you would simply be left with a passive investing approach. If you never see a signal to sell until it is clearly too late, you don’t. Moreover, with the time saved from researching individual companies, you can realistically wrap your head around all of the data since it is mostly reported monthly. This is far from an achievable goal for an individual investor with a day job and a well-diversified portfolio.
The Approach Methodology:
The exit, believe it or not, is the easy part. While there is a lot of proxies to forecast economic downturns, I will focus on just a few for simplicity’s sake. I should also keep some of my tricks up my sleeve, right? These would obviously be expanded for a multi-year, 5–10 hour a week analysis.
In this article I will focus on three big ones: manufacturing data, short term interest rates, and unemployment. The thought being that these are fed and corporation driven indicators. These are institutions with floors of economist crunching the numbers and doing the hard work for you. If the fed sees economic turbulence ahead, it will halt rate hikes. If a corporation sees lowering demand in the future, they will preemptively slow production to prevent surges in inventory. And these hypotheses are supported by the data. If we use short and long term moving averages to distinguish fluctuations from major economic events, we see a high degree of correlation between economic downturns and crosses of the moving averages of manufacturing and unemployment data. Additionally we see a sharp drop in interest rates right at the beginning of each recession. You can also make the case for the treasury yield curve being an even more predictive model than short term interest rates alone; I left this out since it has already been praised as the holy grail of recession prediction by essentially ever financial news outlet. Now none of these predictors are perfect and you may only be able to exit within 10% of a peak but even that would yield significantly greater returns in the long run than a solely passive investing approach.
The entrance is a lot trickier. You will see that while these predictors are good for predicting when the stock market will decline, they are a whole lot worse at determining when it will bounce back. This is due to a variety of reason that I will not go into but it’s result is a less-than scientific entrance. More specifically, I propose a strategy almost entirely unrooted in economics: simply re-entering based on historic index recession declines. The past 10 recessions have seen a peak decline of anywhere from 22–57%. Now it is also important to note that the past two recessions have also both been the biggest since the great depression. This may be anomaly but it could also mean that computers, the internet and the liquidity provided as a result have fundamentally changed the depth of economic downturns. But instead of getting into a philosophical rant, let me get back to the entrance technique. I propose something along the lines of putting money back into an index fund at 25% down from its peak and putting in proportionally more until you reach a 50% decline. If the index shows a 10% increase from its low before hitting 50%, put the rest in. Using this strategy you would buy in anywhere from 15%-35% of the indexes peak depending upon the severity of the recession. Now I understand that this method is relatively cautious and could likely be improved upon but it is more so to give an example of a potential entrance strategy. Even this cautious strategy introduces a low risk way to incrementally improve upon passive investing returns.
Now it should be noted that these approaches are most valid for recent downturns but have not been extensively tested on further back economic down turns. I see how one could make an argument that this is not robust enough to support the approach. However, the drastic expedition of the dissemination of information and the potential volatility enabled by algorithmic changes has allowed for faster price movements. This adds validity to the argument that the markets have fundamentally changed and makes it a bit tricky to predict future recessions due to the limited data (these don’t happen very often). Or maybe you believe this is not the case at all in which I would love to hear what you think!
