What is Mechanical Market Timing?

For decades, investors have debated the best methods for maximizing returns while minimizing risk. One of the most enduring debates among investors is the quest for market timing. Consistent success with timing the market has always proved elusive for one simple reason – humans cannot predict the future, at least not on a reliable enough basis to succeed over time. Think about how we respond to changing weather. Our inability to always predict exactly does not preclude our ability to react when a meaningful new trend develops.

Mechanical market timing is a systematic and rules-based investment strategy that aims to take emotion out of the equation. This isn't about gut feelings or trying to outsmart the market. Instead, it relies on a predefined set of rules, often based on quantitative models, to determine when to buy and sell assets. It is particularly relevant in today’s volatile markets, where emotional investing often leads to costly mistakes driven by fear and greed. This eliminates emotional friction, enforces discipline, and ensures that decisions are consistent and repeatable. This is especially important when the markets face extreme market fluctuation after a long bull market.

This post explores the concept of mechanical market timing, diving into how it works, its advantages and disadvantages, and whether it aligns with your financial goals. We’ll also discuss how it compares to other approaches, such as buy and hold, and why this might be an especially pivotal time for integrating this timing strategy into your portfolio.

How Does Mechanical Market Timing Work?

At its core, mechanical market timing involves:

Defining Clear Rules: These rules could be based on a variety of factors, such as:
- Technical Indicators: Moving averages, RSI, MACD, Bollinger Bands, other momentum-based calculations, etc.
- Fundamental Factors: Price-to-earnings ratios, dividend yields, economic data, etc.
- Sentiment Indicators: Investor surveys, put/call ratios, Economic numbers, VIX, etc.
Developing a Trading System: These rules are then translated into a specific trading system with clear entry and exit signals. Many software developers will use straightforward language well suited for developing scientific and numeric applications such as Python, because of its extensive use of libraries for visualization and data analysis.
Rigorous Back testing: The system is tested on historical market data to assess its potential profitability and risk. This requires a long enough data set that includes at least a full market cycle. This should include slow and fast rising and declining markets.
Disciplined Execution: Once a system is deemed viable, it's implemented with strict adherence to the predefined rules, regardless of personal emotions or market noise.

Pros of Mechanical Market Timing:

Reduced Emotional Bias: By following a set of rules, investors will never eliminate their biases, but it can help to minimize the impact of fear and greed, two powerful emotions that often lead to poor investment decisions.
Increased Discipline: Mechanical systems encourage disciplined execution, preventing impulsive trades and sticking to a well-defined plan.
Improved Consistency: By eliminating human emotions, mechanical systems can potentially deliver more consistent returns over the long term. Data has no emotion. If the data points lines up a specific way, the software responds the same way, regardless of the attitude, thoughts, or fear you have at that time.
Potential for Higher Returns: If a system is effectively designed and back tested, it may generate higher returns over time than a simple buy and hold strategy, especially during market downturns.

Cons of Mechanical Market Timing:

No Guarantees: Even the most sophisticated systems can experience periods of underperformance. The best way to look at this is to realize the old adage “No system is perfect, but some are very useful”.
Risk of Overfitting: Systems can sometimes be overfitted to historical data, leading to poor performance in real-world conditions. We have found this step is where most people fail because of their biases. Many model developers inadvertently curve fit their formulas without even knowing it.
Potential for False Signals: Market conditions are constantly evolving, and systems may generate false signals, leading to unnecessary trades and increased transaction costs.
Requires Ongoing Monitoring and Maintenance: Systems may need to be adjusted or even replaced over time to adapt to changing market dynamics.
Expensive to implement: Because of the development and ongoing monitoring, systems are costlier and can be labor intensive. Some systems can be auto traded, but with the ongoing costs, you will always need to evaluate if the additional cost justifies the potential increase in returns over time.

Mechanical Market Timing vs. Buy and Hold

The buy and hold strategy, often championed by many legendary investors, advocates long-term investment in a diversified portfolio, regardless of short-term market fluctuations. This approach emphasizes the power of compounding and the long-term upward trajectory of the stock market. Legendary investors known for this approach such as Warren Buffet are obviously very successful, and it is very hard to argue about their success. The question is not whether the buy and hold approach can produce outstanding results, the question should be “Why can’t more people successfully implement it like Warren Buffet”. When you truthfully answer that question, and realize how emotions influence our behavior, you start to understand how Mechanical market timing might be useful for at least part of your portfolio.

The bottom line is our emotions fluctuate. Optimism about the future or fear about something happening tends to vary over time as new events occur and we look at things with new data. Mechanical market timing attempts to standardize our reactions, by minimizing the number of emotions that creep into our decision-making process. The purpose of this approach is to improve risk-adjusted returns by reducing exposure during meaningful downturns and increasing exposure during meaningful upturns.

Why Mechanical Systems Can Excel in Downturns

One of the key advantages of mechanical trading systems lies in their ability to navigate market downturns. When fear grips the market, investors often make panic-driven decisions, selling assets at a loss. Since fear is something that overtakes everyone differently, those panic driven sell decisions tend to play out over a number of months. This can be long after the data that is continually analyzed has started to change.

Aside from the emotional considerations, it also comes down to simple math. Mathematically, losses will always have a disproportional impact over gains on a portfolio. The damage caused by a 30% decline in your account is greater than the benefit received from a 30% gain. Assuming no interest, if you totally missed a 30% gain and instead stayed in cash, you would need to find a 30% gain someplace else to offset the gain you missed. But if your account declines 30%, you need to make 43% to offset the decline you didn’t miss. That 13% is the disproportionality you are forced to endure from not reacting to major downturns.

However, a well-designed mechanical system can be programmed to identify and react to early warning signs of a market downturn. This could involve selling positions, reducing risk exposure, or even shifting to safer assets. By adhering to predefined rules, investors can avoid the emotional pitfalls that often accompany market crashes.

What if the market turns around and goes up right after you sell? It might help to look at it like you look at insurance. You don’t feel good when you pay your homeowners insurance premiums, and nothing happens to your house. But you are not making a binary bet, that either your house gets damaged, or it doesn’t. You are making sure ensuring that you can recover if something bad occurs. The things in life that truly hurt us are not necessarily bad things, they are those things we cannot recover from.

Why Emotion-Based Investing is Inconsistent

Human beings are inherently emotional creatures. Our investment decisions are often influenced by a range of emotions, including:

Greed: The desire for quick and easy profits can lead to overconfidence and risky investments.
Fear: The fear of losing money can lead to panic selling, locking in losses at the worst possible time.
Hope: The hope for a market rebound can prevent investors from cutting their losses, leading to further declines.
Regret: The regret of missing out on past gains can lead to impulsive trades and chasing performance.

The problem with the markets is that, in the short term, every one of the above emotions can quickly get reinforced. You buy because of greed or fear (FOMO), it goes up for a week or a month, and your decision is quickly validated. You sell for fear of loss, the investment continues to go down, and your decision is quickly validated again.

Another problem is that emotions fluctuate, in varying amounts, because of what has occurred in other parts of life. You may think you are the same person you were a year ago, but you are not if you lost your job or lost your best friend. Events can cause our levels of fear, hope, and regret to change quickly. happened to us.

Quantitative models and systems can work when you can successfully “quantify” something. Even if you are cognizant of when you are more fearful or have more regret, it is very hard to put that feeling into a formula or algorithm. You cannot always define the emotion as 3X this or the square root of this over this.

Howard Marks on Cycles and Contrarianism

Howard Marks, a renowned investor and co-founder of Oaktree Capital Management, emphasizes the cyclical nature of markets. He believes that investors should strive to be contrarian, buying when others are fearful and selling when others are greedy. Howard is correct about the cyclical nature of markets, certainly someone on par with Warren Buffet. He is extremely gifted, a sage investing scholar, and incredibly disciplined. It is very hard for the average investor to bring Howard’s skill set to their investing.

Mechanical systems can help investors embrace this contrarian approach. By identifying and at least adjusting somewhat to market cycles, these systems can potentially navigate market swings more effectively than emotional investors. Significant longer-term moves, or cycles, in the markets tend to be gradual at first, because initially a major shift in events or the environment is not obvious or expected. This topping, or bottoming process can take months or years to play out. During this period, markets can appear to be directionless when you look at it. At its core mechanical systems, by analyzing non-emotional data, hope to detect a change in a cycle before your eyes do.

Why 2025 and Beyond Might Be a Good Time for Mechanical Timing

2025 presents a unique set of challenges and opportunities for investors. The global economy is facing headwinds from inflation, rising interest rates, and geopolitical uncertainty. These factors could increase market volatility and create a challenging environment for traditional investment strategies.

In such an environment, a rules-based approach like mechanical market timing could offer several advantages:

Navigating Volatility: By adapting to changing market conditions, mechanical systems can help investors navigate periods of increased volatility. Longer periods of greater volatility often occur after multi-year run-ups in markets.
Capitalizing on Short-Term Opportunities: In a volatile market, short-term trading opportunities may arise more frequently. Mechanical systems can be designed to capitalize on these fleeting opportunities.
Reducing Emotional Stress: In times of market uncertainty, emotional stress can take a toll on investors. Mechanical systems can help reduce this stress by automating investment decisions.

Final Thoughts

Mechanical market timing requires careful research, rigorous back testing, and disciplined execution. However, for investors who are seeking to improve their investment process and reduce the impact of emotions, it can be a valuable tool. By combining the power of quantitative analysis with a disciplined approach, investors can potentially navigate the complexities of the stock market more effectively and achieve their goals.

A Mechanical market timing model is not a panacea. No model works in all market environments and every model has its own flaws and periods where it underperforms. The key to implementing any investment strategy based on Mechanical market timing is to use multiple models, organized in a way so that you can benefit from each model’s strengths, while minimizing some of the inherent deficiencies that any model has.

Remember, investing is personal. What worked for your neighbor or coworker does not mean it is right for you. Before making any changes, preparation and approaching it with realistic expectations is the key. After interviewing and consulting with thousands of investors over the last 25 years, we have found they all eventually fall into the same trap - their investments did not match their expectations, causing an emotional reaction when this occurs. We will present you with a fuller, more reliable expectation picture of your investments. This allows you to confidently navigate down whatever investing path you decide.

Spend a few minutes with us to see if we are a good fit for each other.