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The Realities of Market Timing

  • Austin Pryor Sound Mind Investing
  • 2010 10 Oct
  • COMMENTS
The Realities of Market Timing

 

For 80 years, the overall trend of stock prices has been upward. This has been the case despite recessions, wars and rumors of wars, energy shortages, and political scandals and upheaval.

This upward trend reflects the underlying strength of the American free-enterprise system which provides a reasonably favorable environment in which businesses can prosper and grow. This means more profits — and more profits means share prices go up in value and more dividends can be paid to the owners. Stock prices, ultimately, must reflect the earnings of the underlying companies.

Bear markets, when they come, have lasted less than one-third as long as bull markets. With instantaneous communication of financial news, millions of people trying to act on the same negative news at the same time creates a traffic jam. Because markets aren't always capable of absorbing a high volume of sell orders quickly, large price markdowns are often needed to entice a sufficient number of potential buyers off the sidelines. After the sellers have been satisfied, the way is clear for a new bull market to begin.

To deal with these occasional bear markets, many investors are attracted to a strategy known as "market timing" in which they attempt to move out of stocks near market highs and buy back in near market lows. Market timing is a strategy where, in its purest form, the idea is to be invested in stock, bond, or gold mutual funds only during favorable market periods (i.e., when share prices in these markets are rising), and then moving all of one's capital to a haven of safety such as a money market fund when prices are falling.

Systems That Try to Anticipate Market Movements

I've never advocated a market-timing approach to SMI's readers (more on that shortly), but let me give you a quick primer so you can get a feel for what's involved. Many different ways exist to make market-timing decisions, but what they all have in common is a structured set of rules to follow, usually called a "discipline." Think of it as a system that automates your decision-making. The system can be based on whatever data an investor believes will be most helpful.

Some timing systems are anticipatory. They are designed to move in and out of stock funds before any change in market direction is obvious.

One common example of this would be a system based on changes in interest rates. Since lower rates are usually good for the stock market, rules could be developed that tell you to buy or sell stock funds based on the level and direction of short-term rates and/or actions of the Federal Reserve.

A different anticipatory system could be based on how cheap (or expensive) stocks are in relation to their earnings or dividends. For example, history shows that the long-term average price-to-earnings ratio (P/E) for the stock market is around 16 (that is, take the profits earned over the most recent 12-month period, multiply that by 16, and that would be a fair price to pay).

By that standard, if the P/E of the S&P 500 were to fall to 10, a timing system designed around P/E ratios might interpret such bargain prices as a buy signal, the theory being that bear markets have often bottomed when the P/E reached that general level. Or alternately, even if the bottom hasn't arrived, it "can't" be too far away.

The advantage of an anticipatory system is that, in theory, it can potentially have you buying very close to market bottoms and selling near market tops.

Anticipatory systems have their disadvantages. One is that such systems may have no mechanism for correcting their mistakes. For example, if the above P/E model said "buy" because stocks were thought to be at bargain prices, what would an investor following that model do if stock prices continued to fall? Logically, lower prices would mean stocks were even greater bargains.

Rather than become discouraged, the system would be shouting, "Buy more!" Prices could fall to absurdly low levels and such a system would never say sell. Of course, this would work to the investor's ultimate good when the next bull market finally arrived, assuming he or she had nerves of steel and didn't throw in the towel.

Another disadvantage of anticipatory systems is that they can potentially miss entire bull markets. When the upmove begins, a system might consider the historical record and, anticipating that the rally won't carry very far, refuse to give a buy signal. This conclusion would be based on probabilities (e.g., "Four out of five times, the market falls 10% within three months of the Federal Reserve doing thus and so"). But what if this is that fifth time? Many market-timers (including me!) missed much of the rally that began two months after the crash of 1987.

Anticipatory systems can occasionally be on the money, but they can be difficult to live with emotionally. If you're not prepared for that aspect, you might abandon ship at the worst possible time.

Systems that Try to Follow Market Movements

A different approach to building a system is to respond to market events rather than try to anticipate them (i.e., a trend-following system). Most commonly, such systems focus primarily on stock prices and have rules based on moving averages and/or the rate of price changes.

The advantage of this focus on price is that it is highly unlikely for such systems to ever be on the wrong side of a major move in the market, either up or down. If stock market momentum is up, a moving average approach will soon give a buy signal. If the market is moving down, it will soon be selling everything! It has singleness of purpose.

One disadvantage of trend-following is that it occasionally gets "tricked" by focusing only on price. Sometimes prices will move just far enough to trigger a signal in one direction, and then reverse course and soon trigger a signal in the opposite direction. This is called a "whipsaw." Fortunately, trend-following systems are never wrong for long, and so their occasional losses are usually small.

Another drawback is that selling points will never be very close to market tops (and vice versa). Let's say that the market has been moving up and you're fully invested in stocks. You want to sell when the trend turns down. Obviously, you can't reasonably say the trend has turned down until there has been a meaningful retreat from the highs; a minor sell-off wouldn't be convincing. So a lot of your paper profits can be lost between the market top and the decision point where you actually sell your stocks.

Market-Timing Newsletters 

Most investors aren't willing to spend the time needed to develop their own market-timing system. Those drawn to such an approach usually rely on one or more subscription-based investment newsletters. Many newsletters offer timing advice, but only a handful specialize in it.

Let's look briefly at three of the better-known timing newsletters to see how they have fared during the past decade when we experienced not one, but two, very difficult bear markets. This was a ten-year period in which an effective timing approach could really shine.

Look for Part II of this series next week.

 October 2010

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