RELATED TOPIC --> | 31-year back-test of our Repo-rate timing strategy on JSE |


There are various factors in the classic economic cycle that effect stock market performance as depicted below.

We have discussed "Historic Valuations" and "PE Trend" in our "History of JSE Bear markets"
paper, and this section focusses on the more economy-related issues such as interest rates, inflation, etc.

Stock markets lead the economy by 6-12 months. They dip before the economy dips and they rise before the economy bottoms out. Trying to assess the state of the economy to predict stock market cycles is not only difficult but not very useful. GDP, employment and manufacturing data come out months after the actual events. Interest rate cycles however provide important clues to stock market direction. Generally speaking periods of falling interest rates are one of the most powerful factors that lead to rising stock markets and predicate major bull markets.

Interest rates are one of the most powerful forces that give the stock market direction. Falling interest rates encourage investors to move money from fixed income instruments back to the share market, since the interest they are receiving from their cash or bond yields is diminishing. Lower interest rates boost company profits due to reducing the costs of debt financing and raising capital. Finally, lower interest rates eventually find their way to the consumer and eventually unlock their spending potential, which in turns boost corporate earnings.

In his famous book, "Winning on Wall Street" Martin Zweig tested a simple mechanical stock picking strategy of buying the S&P500 when interest rates dropped and switching to bonds when interest rates rose, from 1954 to 1996. This strategy delivered an annualised return of 15.5% versus the S&P500 buy-and-hold's 7.9%. The interest rate cycles delivered correct timing signals a stunning 81.8% of the time! Zweig used this market timing strategy together with his  stock picking methods to become one of the most successful modern day investors. 

We did a similar Market Timing exercise on the JSE over the last 31 years, to calibrate and create our own Repo-rate based timing strategy and display how it worked in the last 12 years below:

The shaded blue areas indicate times to be in the share market and thus their left borders signify BUY signals and their right borders signify SELL signals (when interest rates started their rise.) Ignore the orange lines/arrows as we cover these later. During high interest rate periods (the unshaded areas) we have our money earning interest in a bank account. During declining interest rate periods we have our money in the stock market.

The arithmetic growths achieved during the 5 periods depicted above are shown below for comparison. Both a "buy-and-hold" and "timing" strategy would enjoy exactly the same growths during the periods we are vested in the JSE, and their differences come about during the non-vested period when we step out the market with the switching strategy. The differences in the non-vested periods are significant, namely -14.24% in the stock market versus 20% interest growth during 02/02 to 06/03 and 11.2% JSE growth versus 30% interest related growth during the 06/06 to 12/08 period.

Using this timing method versus a buy-and-hold JSE:ALSH or "money in the bank" strategy showed remarkably superior returns (let alone far less risk as you are kept out of the bear markets!) The chart below shows the returns achieved for each period under review. For the "banked" periods we calculated the average daily prime rate minus 3 on a monthly basis to estimate interest earned, but in real life or in the money markets you will probably be able to do even better than this.

Think about what the above chart is telling you. Over the 12 year period, you almost doubled the performance of the ALSH whilst having your funds exposed to the JSE for only 62% of the time! The risk-adjusted returns of this strategy would have been far superior to the buy and hold strategy.

We note that the SELL signals generated when interest rates first rise, can be premature (overly conservative) in getting us out of the market. The first interest rate increase after a period of declining rates is our first "warning" that the market is now becoming "dangerous" and the "party may soon be over". But the frustrating thing is that excellent returns can be achieved from these final "dying moments" of a modern bull run and in fact these "last gasps" can last for up to 2 years, as shown in the 2006-2008 period above!

What you will see however is the market to start "stumbling" more and becoming more volatile in its dying stages, as shown in the June 2007 to May 2008 period two charts above. One can take your chances in trying to walk the tightrope and judge the market peak yourself but this is very difficult. A safer option is to allow interest rates to rise by another 2.5% before selling-out whilst keeping a very close watch on market Technical Indicators for signs of weakness. In this case, if your first "warning" trigger was a rise in the prime rate from 13% to 14%, as occurred in Feb 2002 then set your sell trigger to when it gets to 15.5%. In the case of the first increase from 10.5% to 11% on June 2006 we would have set our sell trigger to 13%. 

These "extended signals" are indicated by the orange lines and arrows in the "Classic Interest Rate Timing Strategy" chart right at the top of this page. As can be expected, this would significantly boosts your returns even more, although it introduces a (manageable) element of risk into your strategy. The results of this improved strategy are shown below:

We see in the modified strategy that we are in the JSE for 81% of the time and "in the bank" for 19% of the time. The modified timed strategy improved significantly over the previous example. If you were a little more cautious, you could also start progressively offloading your portfolio into cash with each subsequent rate rise from the initial one. For example, offload 10% of your portfolio with each 0.25% rate rise, starting with the initial increase. If the rate rises a full 1% then offload 40% of your portfolio. Obviously this would diminish your returns but also lower your risk.

At PowerStocks, we developed a market timing system called PITBULL Ver 1.0 that uses interest rates exclusively as shown above, but with some modifications. This system delivered 45,000% growth on the ALSH index over the last 31 years versus the ALSH's 8,500% growth, by only being in the market 50% of the time! The highly detailed back-test and results of this timing strategy are available in the 31-year back-test link at the very top of this page. With PITBULL Ver 2.0, we make even further simple improvements to enhance returns to 66,000% over the same period by only being in the JSE 50% of the time.

You can read about PITBULL at the strategy pages or by clicking on the banner at the bottom of this page. We also track a live PITBULL Ver 2.0 Model portfolio which you can view from the SCOREBOARD menu. Fianlly, over at the Weekly JSE Pulse page we provide updated weekly timing signals for subscribers that want to use these signals to time their market entries and exits.


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