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Frequently Asked Questions
The Sadowski Trend Analysis Timing System (STATS)
What investment strategies do you use?
I have always felt a keen drive to examine and challenge the dominant buy-and-hold ways of investing. I have sought to find an evidence-based, empirically verifiable way of successful investing that is an effective and safe alternative to the current orthodoxy. Believing that investing can be truly a science, not an art, means that it has to be rule-based and replicable.
My system (the Sadowski Trend Analysis Timing System, or STATS) is an investment method that is radically different from the conventional efficient-market theory, Modern Portfolio Theory approach of a passively-managed, diversified portfolio of securities allocated into various strategically-based asset classes.
My system flies in the face of the established practices inherent in the just-mentioned theoretical and practiced approaches to portfolio management. At first blush my system would appear to break all the rules of established sound investment principles, violating commonly-accepted principles by the financial advisory profession for optimum investment returns and controls of risk in accordance to a client’s financial state, investment objectives and risk tolerance. As I will show here, my system is highly risk-controlled and compliant and amenable to an individual’s financial profile and investment objectives.
My method of investing is a trend-following, technically-based investment system that in theory and practice is incompatible with a buy-and-hold, asset-allocation method. These two ways of investing—buy-and-hold and trend timing--are, in fact, diametrically opposed and mutually exclusive.
Much of the conventional professional financial advisory practice hinges on the random walk theory and efficient market hypothesis. According to these tenets, stock prices are random and unpredictable. The efficient market hypothesis states that stocks almost always trade at their fair value because their prices reflect all relevant information: the prices are already “baked in.” The efficient market hypothesis states that identifying, delineating present and future value in a stock, finding undervalued stocks or bonds or any type of security--based on any fundamental or technical criteria—is a futile task. Stock picking is risky and mostly luck. Because markets are efficient, no amount of information or analysis will create an advantage for an investor. Only the market knows what it’s going to do.
One could take these academic pronouncements and succumb to the gloom and doom of the nature of the market. But instead of throwing up their arms and saying that nothing can be done, professional advisors believe there are ways to work with the market to some advantage, if not defeat it. You can’t overpower the weather, but you can minimize its damage.
In general, how do you view the efficient market hypothesis and random walk theory?
The efficient market hypothesis states that stock prices reflect instantly all information and news that would affect it and investors cannot get an advantage by beating others to the information. The random walk theory states that there is no relationship between present and prior (historical) prices, thus stock prices are random and unpredictable. The long-term track records of various investors and investment systems invalidates these theories. Successful investment systems have found ways to extract information, both fundamental and technical, to predict the movements of securities with an accuracy greater than through chance alone, proving that price movements are not entirely random.
Studies show analysts’ inability to predict next quarter earnings better than chance. This is used as evidence to support the random walk of stock prices. The problem with such studies and theories is that they completely leave out the fact that markets have measurable trends and momentum that are independent of fundamentals. The fact that most stocks move together in up and down trends (with large differences of movement among them) regardless of their individual fundamental makeups shows that there are other factors involved in price changes that are ignored or minimized by theorists. I believe these trend movements are engendered by a combination of psychological perceptions of the markets and the economy, as well as by the cyclical dynamics of supply and demand forces of the market.
You don’t think much of asset allocation. Are you against the principle of diversification? How do you justifiy a single-ETF portfolio?
No, not at all. As I said, asset allocation has its place in a conventional model of investing, because it is the best available strategy for that kind of approach to investing. My STATS method uses what I call “linear diversification.” Instead of diversifying a group of securities at one time, what I call simultaneous diversification, I diversify broad index and sector funds (individual stocks are not desirable in my system) across a timeline one at a time. Because I have so much confidence in my timing system and the selection process and its safety, there is no need to waste time in messing with multiple funds or securities. In my system, too many stocks or securities clog up and dilute the results when I have a single ETF that strongly meets my criteria. An index or broad sector ETF, consisting of hundreds of companies, is a big enough basket of stocks to ensure enough diversification in my system. I call it linear, because once a trend in that index or sector has run its course or taken a breather, I look for another ETF to jump onto if it shows a stronger trend. After exiting an ETF I often go back to the same one after a pullback or breather and it starts trending again. The reason I often go back to the same ETF is that most of the markets are hugely correlated much of the time and often there is no other index or sector that stands out. My preference for TNA is an example. If the market is largely correlated (indices and sectors are moving in close unison), my first choice is the Russell 2000 small caps triple-leveraged TNA. With small caps you get more movement, more bang for your buck. The legendary fund manager Peter Lynch favored small caps, as I do, because they simply trend more. Historically, there’s no contest between small and large caps for overall returns. A very pronounced correlation anomaly occurred in spring 2014, as the small caps stalled and faltered, while the larger caps were moving robustly up. Of course, this freaked out some people, because the small caps usually lead, but this time they were laggards. A divergence like this was alarming and some people saw it as a sign that the market might be in the process of collapsing. Well, in my linear diversification system, I saw opportunity, that the other indices and sectors were marching on, and so I exited TNA and jumped onto SOXL, the triple-leveraged semiconductor ETF that was trending more strongly than just about anyone else. And it has paid off.
Your investment method uses market timing. Hasn't the validity of market timing been discredited?
Most financial advisors disapprove of "market timing." Most, although not all, academic studies show that market timing doesn't work. First, many of those who are against market timing actually use market timing in their investing without realizing it. But that's another topic. The problem with with making a blanket assertion that market timing doesn't work is that there are an almost infinite number of ways to time the market, both with fundamental and technical analysis. Because there are so many ways to time the market, so many variables, it is not valid to use a broad brush to declare that market timing doesn't work. If some forms of market timing work (although in the minority), is it fair to say market timing doesn't work?
What is your response to the fact that many respectable academics who have studied the topic say that markets are random and you cannot predict the market.
As long as stock markets have existed it’s been asserted that the stock market cannot be predicted. The classic book A Random Walk Down Wall Street by Brandon Malkiel is the Bible of these believers. I understand the arguments. I understand that you can by sheer luck flip ten heads in a row. I understand that a randomly generated chart can look like an actual chart of a security. But that only shows examples of randomness, but doesn't prove the intended point that stocks behave in the same random way. For some reason those that say markets are random and unpredictable either are not aware of or ignore the studies and tests that have been done that differ with this notion and point of view. Long-term tests using technical indicators such as oscillators, moving averages and relative strength analysis clearly disprove the erroneous notion of randomness. My own system, not scientifically proven or published in a journal, predicts the market more than 80 percent of the time. Nobel Laureate William Sharpe (of Sharpe Ratio fame), said skeptically that one would have to predict correctly over 74% of the time to beat a passive benchmark portfolio, such as an index (“beating the market”). Other researchers have placed the necessary percentages of winning trades as ranging from 69% to 91%. So far, in my limited time frame of four years, I have succeeded beating the market with over 80% correct predictions.
What do you say about the fact that most academic studies have concluded that one cannot time the market consistently.
Most people cannot successfully time the market and beat the system. Yet there are traders who do it year after year. The only way to do it is with a proven system. Few people are able to come up with their own profitable timing system. There are a multitude of ways to time the market, because there are a staggering number of technical tools and indicators and varying ways to use these tools and indicators. Most critics have not even examined the different ways technicals can be used in investing. Some closed-minded conventional investing experts who believe in evidence-based research even compare technical analysis to astrology, completely ignoring the empirical evidence that contradict them. Successful systems are available through timing newsletters and services. But just because most people can’t come up with a system, it’s unfair to broad-brush it and say that timing doesn’t work.
What do you say to the critics of market timing who note that by not being in the market all the time you miss out on some of the best days of the market?
This is one of the persistent arguments used for buy and hold and against market timing, yet is very flawed. This argument is very disingenuous and misleading because it is presented in a one-sided way that excludes the consequences of being in bear markets. There are two sides to the coin, and the other side is that your gains from the best days are devastatingly wiped out in the worst days of the market. This is true even though historically the markets are up 70 percent of the time (stocks are much more often in bull markets rather than in bear markets).
STATS, like all market timing, cannot predict the absolute tops or bottoms of markets, but by capturing much or most of the market up movements, and avoiding most of the losses and down sides of the markets, you end up beating buy and hold and the market handily. The superiority of market timing is borne out not just by the STATS track record, but also empirically with studies over longer time periods using specific technical indicators, such as various oscillators and moving averages and price movement measures to signal moving in and out of the market to avoid the largest down periods.
The superiority of timing is very clearly demonstrated in Sy Harding’s online Street Smart Report. Harding uses a simple seasonal approach, the best six-month strategy, of market timing that was first made prominent by Yale Hirsch, publisher of the Stock Trader’s Almanac. The seasonal investing strategy is based on the historical fact that markets perform the worst from November 1 to April 30 during most, if not all, years. Thus by only being in the market May through October, you capture most of the up days of the market, and avoid most of the down days. This has been empirically proven to beat the market and buy and hold. Harding improved this timing system by adding the MACD technical indicator signals to modify the monthly in and out dates, adding more precision. His remarkable track record can be seen on his website. A summary of many of these timing strategies can be found in what I consider to be the classic textbook on the subject, All About Market Timing by Leslie N. Masonson.
You say many people use market timing without realizing or acknowledging it. Please explain.
Market timing is a dirty word in many quarters. Market timing is seen as being antithetical to conventional buy-and-hold investing. Market timing is defined as using indicators and data to be in and out of the market in various ways. These indicators and data can be fundamentals and technicals. Most often though, market timing is associated with technical trading, using charts and indicators to anticipate (to “predict”) market moves and get in and out of the market. But forms of market timing are used even without what we call technical analysis. Let’s look at the stodgy conventional wisdom of investing. Much of the orthodox investment strategies that financial advisors espouse are time-based. Asset allocations use time factors: the age of investors and time horizons. Allocating assets takes into account the valid belief that various national and international indices, sectors and security types rise and fall differently and without complete correlation in various time continuums. Shifting between equities and fixed assets when interest rates and bond yields rise and fall are also time-based forms of investing. These types of strategies are ingrained in conventional investment protocols, yet these practitioners and adherents of such strategies will decry market timing as being foolish.
How is risk managed in your system?
My system uses certain technical indicators and stop losses to signal an exit from the market that minimizes risk and dangers from market volatility. With US non-leveraged broad index funds (ETFs or mutual funds), there should be no more than an eight percent loss; with leveraged funds the maximum loss allowed is 15 percent. Of course, that is not an ironclad guarantee against larger losses if the market suffers a catastropic one-day "event" that cannot be predicted or avoided.
Why invest in small caps?
I think this illustration says it best: a dollar invested large caps (represented by the Dow Jones Industrial Average or S&P 500) in 1926 would have grown to over $3,000 dollars today. One dollar invested in small caps (represented by the Russell 2000) in 1926 would have grown to over $50,000 today. To repeat, that’s $3,000 compared to $50,000. In other words, small cap stocks grew 94% more than large cap stocks. Which market segment would you want to invest in? It’s a no-brainer. Going back the last 15 years (through 2013), the Russell 2000’s 7 percent annualized growth was twice as much as the Dow and S&P 500 (3 percent and 4 percent respectively).
But aren’t small caps more volatile and more risky?
Yes, small caps are definitely more volatile. They are more risky relative to large caps, but not risky in absolute terms if one understands trends and knows how to handle risk. Trend timing done correctly minimizes risk that can be palatable to even the most conservative, risk-averse investor. In fact, trend timing is the safest way to invest.
How does trend timing minimize risk? How can trend timing be the safest way to invest?
Trend timing uses technical indicators and stop losses to protect profits and minimize losses when the markets go down. Trend timing does this better than conventional asset allocation strategies.
Isn’t diversification through asset allocation and re-balancing the safest way to control and minimize risk?
Being heavily invested in bear markets has been shown to be the worst way of investing. But if one insists on staying through the down markets, asset allocation strategies can decrease, but not prevent, the damage. Conventional dynamic asset allocation strategies using passive management are the best way to minimize risk if one invests using the inferior method of buy-and-hold and not trend timing. The limited effectiveness of proper asset allocation is he hallmark of the Modern Portfolio Theory (MPT) approach to investing, which is espoused by the vast majority of professional financial advisors. This is the best way to invest if one does not fully understand trends or the principles of market timing. Asset allocations are ways to try to survive the bumps and crashes in downtrends and bear markets, helping to ease the blows of market losses. Unfortunately, remaining invested during bear markets takes a huge toll on profits that are not well handled with asset allocations unless one allocates all equities into cash or money markets. Buy-and-hold asset allocation strategies are used because investors see no effective aternatives.
Isn’t trend timing a type of active management, which has been largely discredited and found to be inferior to passive (buy-and-hold) investing?
While trend timing can be called a form of active management, it is completely different from the conventional active management used by institutional portfolio managers (mutual funds, endowment funds, etc.). The active management used by fund managers relies on relatively frequent buying and selling, selection and de-selection of stocks and other securities, but, like passive investing, ignores trends and remains largely invested in bear markets. That is where both conventional active and passive management strategies fail, by not protecting themselves adequately from market turndowns and bear markets.
Conventional active and passive management, by being in the market at all times, although being hit by bear markets, by always being invested, is able to capture all the up moves of the market, which more than makes up for the losses in the bear markets, isn’t that right?
This is a good question. True, by being fully invested at all times, you do capture all the up moves of the markets. The argument can be made that since overall the stock market is up 75 percent of the time, and down 25 percent of the time, just by buying and holding you will come out ahead and that your risk is minimized by being invested over an extended period of time. This is true, and borne out that historically, as the market has gained six percent annually over many decades.
What do you think of asset allocation in general?
Asset allocation is a good offensive and defensive strategy for those who see markets as being efficient and random. For those who are able to correctly identify patterns, rhythms and cycles in markets, asset allocation is a terrible strategy. From a trend timer’s perspective, and this will undoubtedly offend or even enrage some people, I equate asset allocation with re-arranging the deck chairs on the Titanic.
Your system uses the triple-leveraged ETFs. Aren’t triple-leveraged ETFs extremely risky and not recommended by most financial advisors?
Most financial advisors warn against using triple-leveraged ETFs and, in fact, many financial advisory firms forbid their staff from recommending these ETFs to clients. The fact is that triple-leveraged ETFs are unfairly maligned and misunderstood—in other words, they get an undeserved bad rap. Triple-leveraged ETFs, just like any stocks or indexes, are only as dangerous as how they are used. My system’s use of 3x ETFs is actually safer than most investors’ use of non-leveraged securities, because my system is in cash during counter-trend periods of the market, while most conventional investors are always in the market, during both up and down trends, meaning investments are theoretically exposed 100 percent of the time. Even when triple-leveraged ETFs are approved, they are only supposed to be used for intraday or short-term daily use. Yet the long-term performance of the 3x TNA far outperforms all non-leveraged ETFs over all time frames (easily verifiable with a site such as Google Finance).
However, and this is a big however, losses during bear markets take a long time to be recouped. Many professionally-managed buy-and-hold portfolios in 2000 would have taken until 2013 to regain what was lost during the two major downturns during that period. Although one can eventually regain losses and even make profits over long periods of time, you can never regain lost time. Is it better losing valuable years waiting to regain what was lost, or better to prevent those losses in the first place and come out way ahead instead? Life is too short. Is it worth losing long periods of time when the loss of that time can be prevented? The answer to that should be obvious. Trend timing takes care of that dilemma.
So you’re saying trend timing avoids the losses of bear markets. Does that mean trend timing also captures the up markets? It sounds too good to be true.
First, trend timing does not claim to capture all of the up markets and prevent all of the down market losses. That would be impossible and unrealistic. No system can claim to be perfect. Trend timing does, however, capture a good part of the up markets and prevents most of the losses in a down market. Trend timing is extremely accurate, but not 100 percent accurate. My particular trend timing system is empirically-tested mechanical and rules-based and deals with probabilities. It does not predict the tops of markets all of the time, but well enough that most of the up market is captured and most of the down market is avoided. The combination of the two produces a superior trading system. If a system claimed to be 100 percent perfect, then that would be too good to be true.
How much volatility and standard deviations can I expect in trend timing?
Depends on system. Also if non-leveraged, double leveraged or triple-leveraged (8, 16, 24 percent stop losses).
What kind of securities does your system use?
My trend timing system is geared to the use of index funds, specifically to the small caps (Russell 2000). The trading signals are specified for the small caps ETFs or mutual funds. Unlike conventional investing, my system is not a passive investing system, but an active one, based on being in the market, long or short, only during up or down trends.
What is the significance of comparing your system to the Modern Portfolio Theory (MPT) model?
The MPT and Post-Modern Portfolio Theory investment method of dynamic/strategic asset allocation has been shaped by pioneering studies in the 1980s and 1990s, such as by Brinson et al and Ibbotson et al, that asserted that proper buy-and-hold asset allocation, a distinct form of passive portfolio management, can beat active portfolio management as well as the stock market indices. An MPT model delineated by Larry Swedroe over a 30-year period, demonstrates that a buy-and-hold properly diversified portfolio of various index funds exceeds returns from just a single index. (Compound returns, MPT model portfolios--varying asset allocations of conservative, moderate, moderately aggressive, highly aggressive: 11, 12, 14, 15 percent, respectively, compared to benchmark, compound returns, S&P 500, 1973-2003: 8%.) Such a portfolio maximizes returns while decreasing risk and volatility (as measured by the standard deviation). The Swedroe MPT model also demonstrates superior returns of a 100 percent index equities portfolio over balanced portfolios that include fixed income securities, with the disadvantage of much greater volatility, as would be expected.
It is my contention that my trend timing system produces better results than the MPT approach. My system not only produces much higher returns, but with risk and volatility that is better or equal to the MPT all-index equities portfolio. Admittedly, at this point my evidence is based on a back-tested portfolio that has only three years duration, as opposed to the Swedroe 30-year time span. I am planning to expand my back-testing to match the 30-year timeframe, and presently am forward-testing with real and simulated accounts. I am convinced and confident, even with the limited empirical data, that my system is solid and reliable, capable of producing superior results.
How can your system be used in a portfolio?
With a conventional portfolio, this trend-traded system can be added to your stock (equity) side of a portfolio in a proportion according to your objectives and risk-tolerance level. After trying this method, some investors may find this trend system so compelling that they may decide (carefully) to make it their sole, simple solution to investing.
What suggestions can you give to cautious, risk-averse investors who want to try this system?
One should not try any new investment method without giving it a riskless or near-riskless test run until one is comfortable using it. When learning to drive a car, one doesn't start immediately on freeways and busy thoroughfares. Similarly, one should ease into a new investing approach carefully and gradually, the way one learns to ride a bicycle with training wheels. One can do this with paper trading, simulated accounts trading, or trading very small amounts of real money. One way to do this is to only initially invest a very small amount one is willing to risk losing (or such a small amount that it would amount to "play money"). Another safe way is to do paper trading or simulated trading: certain sites, such as Investopedia provide simulated acounts where one can practice and experiment with simulated trading. Another way to develop a comfort level and confidence in a new investing method in dealing with intimidating market fluctuations (volatiliy) and to minimize risk is to "scale in" and "scale out," which means gradually going in and out of trades with small proportions of the total amount intended to invest. One can do this scaling with, say, 25% or 33% increments. Thus one could scale in with one-third amounts, until the full total is invested. Scaling out would be removing one-quarter or one-third amounts until completely out of the market.
Victory over the market
Investment success with
STATS
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