What if we could construct a strategy with a correlation close to 1 with a perfect market timing strategy? Can we estimate what its returns would have been? Can we use these estimates to understand what the market would have “charged” for a perfect market timing strategy?
To answer these questions, first let’s define what a perfect market timing strategy needs to know and what it is. A perfect market timing strategy needs to know, with certainty, the future returns of the assets that are eligible for investment. Armed with this information, the perfect market timing strategy always chooses the highest returning asset to invest in. For example, imagine a strategy that can invest in US stocks [for simplicity, the S&P 500 Total Return (TR) Index] and One-Month US Treasury Bills. It rebalances once per month and on that day knows with certainty the return of US stocks and US Treasury bills over the following month. This perfect market timing strategy would then invest all in equities or all in the One-Month US Treasury Bill, depending on which one will have the higher return over the following month. The challenge here is obvious. How can we know with certainty what the future returns on any asset class will be? Without that knowledge, there is no way to create a perfect market timing strategy. Or is there?