April Fools!

I hope that everyone who read this morning’s version of this post (see below) figured out that it’s an April Fools’ joke. All I did was examine past S&P 500 returns and concoct the silly “zone theory” to exactly pick out which months had negative returns and avoid them.

Following this theory really would have returned 28% per year. But, anyone could make money knowing future stock prices in advance. Zone theory was tuned perfectly to past data, and there is no reason to believe that it would work in the future.

There is also no reason to believe that you can predict what will happen next month by looking at a stock chart for the past few months. What will happen depends on information that just isn’t in the charts.

So, forget about zone theory and other crazy market timing theories and invest for the long term without obsessing on short-term fluctuations.

Market Timing Breakthrough!

After wasting so much time trying to show that market timing can’t work, I stumbled across an amazing strategy called “zone theory.” An investor using zone theory to avoid down months in the S&P 500 from April 1991 to March 2008 would have averaged 28% compounded yearly! Compare this to the pathetic 11% per year earned by a buy and hold investor.

How Zone Theory Works

Using zone theory is very easy. Here’s how. Each month’s S&P 500 return is slotted into a zone as follows.

Zone 0: less than -4%
Zone 1: -4% to -2%
Zone 2: -2% to -1%
Zone 3: -1% to 0%
Zone 4: 0% to 1%
Zone 5: 1% to 2%
Zone 6: 2% to 3%
Zone 7: 3% to 4%
Zone 8: 4% to 6%
Zone 9: more than 6%

At the beginning of each month, look at the returns for the previous 4 months. Then slot these returns into zones. Let’s say that the past returns were 7% (last month), 0.5% (2 months ago), -3% (3 months ago), and 2.5% (4 months ago). Using the table above, we are in zone number 9416.

Each zone number corresponds to a particular shape in the chart of past returns. We can then use this shape to predict whether stocks will outperform interest on cash for the next month.

Most zone numbers are bullish for stocks. We just need a list of zone numbers that indicate problems in the stock market. Here is the list of zone numbers that predict a bad month:

0305, 0307, 0314, 0575, 0722, 0740, 0869, 0890,
0926, 1089, 1490, 1753, 1817, 1920, 2495, 2558,
2617, 2785, 2825, 3057, 3072, 3092, 3149, 3181,
4003, 4374, 4616, 4625, 4654, 4900, 4929, 4950,
5268, 5290, 5501, 5522, 5546, 5557, 5558, 5584,
5751, 5895, 6119, 6178, 6187, 6373, 6545, 6808,
7224, 7243, 7346, 7403, 7472, 7536, 7818, 7852,
7855, 8098, 8178, 8246, 8258, 8469, 8476, 8691,
8715, 8899, 8904, 9052, 9208, 9261, 9686, 9898

All an investor has to do each month to use zone theory is figure out the zone number for the past 4 months of returns. If the number is in the list then sell stocks and wait until next month. If the zone number isn’t in the list, then buy stocks. It’s that simple!

The Results

A buy and hold investor investing $100,000 in the S&P 500 from April 1991 to March 2008 would end up with $500,000. Compare this to the zone theory investor who would have $6.5 million! That’s 13 times as much money! Holding stocks when the market is going to go down is for suckers.