Analysis of James Stewart’s “Common Sense” Stock Market Timing Strategy

Assisted by a reader in discovering strategy details, we analyze here the “Common Sense” stock market timing strategy developed by James Stewart. He often refers to this strategy in his “Common Sense” columns in SmartMoney.com. The essential mechanism of this strategy is to move some funds from stocks to cash (cash to stocks) when the stock market is relatively high (low), defining high and low based on percentage changes from prior buy and sell dates. The strategy focuses on the NASDAQ Composite Index as a proxy for equities. Using comments from James Stewart’s columns to construct the strategy and daily NASDAQ Composite Index closing levels and 13-week Treasury bill (T-bill) yields over the period 2/5/71 through 5/8/09, we find that:

Defining descriptions of the Common Sense strategy come from two articles, an October 3, 2000 article entitled “Why I’m Buying Now” and a November 7, 2000 article entitled “Value or Growth? Who Cares?”, as follows:

“My formula is simple: I begin selling at intervals of 25% gains, approximately 5% of my assets each time. I will have reached a full cash position at a 75% gain. The target numbers based on the Oct. 12 NASDAQ close are 3844, 4613 and 5382.”

“If you sell 5% of your portfolio at intervals when the market registers gains of 25%, 50% and 75%, you will end up with more than the 10% cash that I indicated was my target. Specifically, you end up with 14.26%. But rallies in which the market rises 75% are unusual. Since the average rally is closer to 50%, I will have raised 9.75% cash in the more typical rally, and more than that when the market gains more than 75%.”

“Except in the rare incidents of a selling climax, I would never commit all my cash at once. Let’s hypothesize that the market continues to decline. If I spent 20% of my cash, as I did last week, I force myself to wait for a further 5% decline, and then allow myself to invest 20% of what remains. So I never completely run out of cash. Should the market drop 30% (a pretty severe correction by historical measures), most of my cash will have been committed. Obviously, you can adjust these figures to whatever level of risk makes you comfortable. The important thing is to have a disciplined approach. Otherwise, your emotions will run away with you and with your chance for superior returns.”

This description is not completely clear and consistent. It is clear that sequential gain or loss thresholds are increments calculated on a fixed date based on a set number of points rather than a floating percentage change. The description also indicates an intent or expectation that the percentage of funds in cash will be low compared to the percentage of funds in stocks. Based on the description, we establish the following rules for testing the Common Sense strategy:

• Each time action changes from sell to buy (buy to sell), calculate a new set of sell (buy) targets, but continue using the previous set of sequential buy (sell) targets.
• Establish buy (sell) targets on a fixed number of points that represent 10% (25%) increments based on the level of the NASDAQ Composite Index at the time of calculation for each set of buy (sell) targets.
• Start with 5% in cash and 95% in the NASDAQ Composite Index on 2/5/71 (arbitrary but in accord with the intended low percentage in cash).
• Move 20% of cash to stocks upon hitting a buy target, based on daily closes.
• Move 5% of the value of stocks to cash upon hitting a sell target, based on daily closes.
• Assume round-trip trading frictions (fee plus bid-ask spread) of 0.1% of assets (could be high or low depending on account size).
• Assume the cash portion of Common Sense strategy funds earns contemporaneous T-bill returns.

Over the entire sample period, these Common Sense strategy rules generate 81 buy/sell signals, an average of about two per year. As shown on the following chart (log scale), based on cumulative returns from initial investments of $100,000 at the close on 2/5/71, the Common Sense strategy generally tracks or modestly underperforms buying and holding the index (terminal values $1,630,730 versus $1,763,560). As of the 81 trading dates, the Common Sense strategy beats buy-and-hold 31% of the time, but it has not been ahead of buy-and-hold since 1992.

The average return between trades is 4.5% (5.0%) for the Common Sense strategy, with volatility (standard deviation) 14.1% (17.1%), so the strategy does modestly reduce volatility (because of the cash holding). The cash holding peaks at greater than a third of Common Sense strategy funds in early 2000.

The performance of the Common Sense strategy is sensitive to assumptions/parameter settings as follows:

• Performance systematically but only modestly improves as the movement of cash to stocks per buy signal increases above 20%.
• Performance systematically and fairly rapidly degrades as the allocation of stocks to cash per sell signal increases above 5%.
• Performance of course degrades with an increase in trading frictions.
• Performance of course degrades with imposition of any capital gain taxes.

In other words, the percentages used to shift between cash and stocks are probably more meaningful for outcome than “whatever level of risk makes you comfortable.” For no settings of the per-buy and per-sell transfers of funds between cash and stocks does the terminal value of the Common Sense strategy match or beat buy-and-hold for 2/5/71 through 5/8/09. However, because of a NASDAQ Composite Index crash early in the sample period (1974), it is possible for the Common Sense strategy to beat buy-and-hold by starting mostly in cash rather than stocks. The opposite profitability responses to increasing cash-to-stocks and stocks-to-cash percentages may reflect a tendency of stocks to fall more quickly than they rise.

The Common Sense strategy appears to misplay, at least for the stocks-to-cash actions, the forces of momentum and reversion in the stock market. These actions appear to bet on reversion over time frames when momentum tends to dominate reversion. Said differently, the system appears to sell too early on average. Much academic research points to two ways to exploit the momentum-reversion cycle: (1) intermediate-term trend following, (2) long-term value investing. The Common Sense strategy appears to try to exploit value at a mostly intermediate-term horizon.

In summary, the Common Sense buy-low/sell-high strategy appears not to be an effective asset allocation approach because it is somewhat out of phase with momentum and value return horizons.

See Guru Grades for a snapshot of the accuracies of various experts in predicting the behavior of the U.S. stock market, including links to detailed individual evaluations. Since the methodology above is not comparable, we do not include James Stewart in the snapshot.

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