Market Timing Strategies

Market timing sounds easy. These strategies involve moving between risky assets, such as stocks or bonds, and less risky short term securities like Treasury Bills based on "technical", "fundamental" or "quantitative" analyses. Reduced to its core proposition, market timing means "buying low and selling high." Identifying high or "overvalued" versus low or "undervalued" is the complicated thing. Since riskier assets usually have higher returns over longer periods, staying "out of the market" or invested in less-risky short term securities can mean a considerable sacrifice of overall return.

It was Issac Newton who in 1768, after being wiped out in one of the many stock market crashes of his era, said:
"I can calculate the motions of the heavenly bodies but not the movements of the stock market".

His lesson has been learned by most active investors since then. The pricing of long term financial assets like stocks or bonds involves all components of the human condition; fear, greed, optimism, pessimism, crowd psychology. Politics, economics, revolution, natural disaster, technology also have impact.

Vain attempts to divine the direction and outcomes of "the market" have involved astrology, superstition and the supernatural.

Academics have surrendered unconditionally. After quantitative techniques and supercomputers proved duds in predicting the financial future, the most highly educated and qualified financial researchers ran up the white flag of the "efficient market". In their rational world, everyone knows everything and it is only random chance that moves markets in a dice-throwing "stochastic process". Basically, they reasoned, no one could predict the market since there were so many smart people trying to do it. They then set about proving this, hopefully making their insulated lives easier since they would never have to stick their necks out with market predictions.

For most investors however, market timing is too attractive to let pass by. If one could participate in all the 25% up years in the stock market and pass by the -25% years in TBills with a modest 5% return, the rewards would be huge. Even capturing a little of this outperformance would lead to a superb performance compared to a "passive" or fully invested strategy.

A market timing strategy is conceptually easy to understand. Stay invested when the market is up or flat. Avoid the downturns. The market timer develops signals to identify what condition a market is in. An overvalued market is called "expensive", "overbought" or "overextended". A normal market is "fairly valued". An undervalued market is "cheap".

The market timer can use a variety of measures to judge the status of the market. These techniques are a combination of technical, fundamental and quantitative indicators and measures.

Technical Indicators

The technical indicators are based on "price" and "volume" movements and patterns. The technical analyst looks at the patterns and movements independently of their causes. It is patterns alone that tells the state of the market. For example, the analyst might see a "topping" pattern developing in the overall market or one of the important sectors from his charts. A "head and shoulders" formation would see the market index rise steeply, fall and then rise again. This would be a very "bearish" or negative signal pointing to a large and sudden drop in the market. The analyst might discern the depth of the fall from the length of the neck or relative height of the shoulders. Other technical indicators involve the "volume" statistics or trading activities of investors. A sudden drop in trading activity or a large differential between smaller and larger stocks would be an indication of a potentially large move, with the direction dependent on what "expert" investors are doing compared to individuals.

Fundamental Indicators

Fundamental indicators are financial and economic measures that affect the overall valuation of the market. A good example of this would be money supply. Generally, a loose monetary policy and expanding money supply indicate healthy financial markets. When monetary policy is tightened, as in 1994, the price of longer term assets like stocks and bonds fall as money and credit become scarcer. Another fundamental measure would be the dividend yield on stocks, the dividend divided by the stock price, both the absolute level and the relative level compared to bonds. From a historical standpoint, when the overall dividend yield on the stock market is below 2%, independent of other factors, this means that the stock market is expensive. When the dividend yield on stocks is low relative to bond yields, this means investors are willing to pay more for stocks relative to bonds than has generally been the case historically.

Quantitative Measures

Quantitative techniques involve associating different market measures or "variables" in quantitative equations or "models". For example, an analyst might "build a model" that related the movements in stock prices to money supply, dividend yields and economic activity. From this, he would attempt to indentify the periods when the market had setbacks. The analyst would then develop some "decision rules" or guidelines to dictate his trading positions that would be programmed into his model. This type of investing is formally called "Tactical Asset Allocation" (TAA). It has become very popular and results in large flows in modern financial markets.

Pros of Market Timing Stock Strategy

There are certainly a large number of investors who swear by the market timing strategy for buying stocks. Such people tend to be big fans of technical analysis which seeks to draw correlations between current market conditions and those which affected historical stock prices. It is not uncommon for a great deal of spreadsheets, charts, and graphs being generated when trying to employ market timing as strategy for purchasing stocks. All of these are generated in order to identify any potential trends in the market that may indicate a significant shift in share prices. However, aside from looking very busy and investing a lot of effort, there are a few pros to this investment approach for stocks.

Cons of Market Timing Stock Strategy

The most fundamental problem with the market timing stock strategy is that it remains pure fantasy, at least according to most investment experts. After all, if anyone truly could predict the rise and fall of stock prices with any degree of certainty, then we would all be billionaires because such a strategy could be documented and replicated. But even Warren Buffet does not ascribe to this approach and neither do most investment professionals. There are almost an unlimited number of market and world variables that may ultimately affect stock prices.

Another big negative with the market timing strategy is the fact that it generally involves a large number of transactions, especially when compared to the buy and hold method. Buying and selling all those stocks requires commissions which can start to take a larger and larger chunk of profits - especially when the market doesn't react in the way you predicted. In order to really be effective, a market strategy tends to require a larger capital investment. This allows the investor to purchase a larger number of stocks and thus not need to make as large of a return on the sale price in order to still make a profit.

The differences between bid and asking price can also eat into the profits of a struggling market timing investor - also known as the bid/ask spread. An investor may bid a price for certain stock and be told that it is available, but by the time the actual transaction is made - the asking price actually charged by the exchanges may be higher. Again, the difference may seem insignificant but it can make a large difference between a good and a bad day in the life of a market timer.

Although market timing is an approach that millions of investors pursue every day on exchanges around the world, the truth is that it tends to carry more risk than reward. With the erosion of profits due to transaction fees and the bid/ask spread, market timing tends to require larger investments of capital in order to be worthwhile. While no investment strategy for buying stocks has proven to be risk-free and a sure thing, there are other options that tend to be safer investment alternatives.

Does Market Timing Work?

It has become accepted wisdom in financial circles that it is impossible to consistently "time the markets". This has resulted partly from the theoretical academic arguments that no one can have such an advantage (legally!) in their "efficient markets". In practice, the complexity of modern financial markets means that it is very, very difficult to predict the vast number of variables that can affect the markets. Who knew that Saddam Hussein planned to invade Kuwait in 1990 and the price of oil would soar? An investor predicting the unification of Germany and its resultant affect on the capital markets would have been shipped to the funny farms only a couple of years before it happened.

It is possible to establish a valuation level for the markets, like a stock. Compare these tasks. A small company might have a few competitors, a known product line and management. The cash flows can be identified and assessed. Even so, where we can value this company, its stock might not be appropriately valued for years and its future prospects depend on the economy in general. What about the market overall? Who is the management? What matters most, monetary policy or fiscal policy? What are demographics doing to demand? What about international considerations?

That is why most market mavens have one or two great predictions before they are hopelessly out to lunch in the forecasting wilderness. While it is possible to tie it all together a few times, it is virtually impossible to do it consistently.

Most good market strategists only try to indentify "extremes" when things are very overvalued. They stay invested until these periods, knowing the smaller swings are "noise" that usually work themselves out. Even so, staying in cash until the eventual crash comes gets harder and harder as the markets run ahead. Usually the final charge of the bull market results in public "bears" being hopelessly discredited and throwing in the towel at exactly the wrong moment.

Should you time the markets?

Should you time the markets? Only if you have the necessary insight and discipline to know when to "hold" and when to "fold" as the song says. Both of these are very hard to come by. For most of us, risk is having your money available when you need it. If you can't afford a 30% drop in value, you shouldn't be in longer term assets in the first place.

If you decide to time the markets, remember one thing. Those who are really good at market timing aren't going to do television and newspaper interviews just before the crash. You'll only know what they did a few months after the fact. If you can't do it yourself, you probably shouldn't try.

If you only invest in stocks when the guys at work have made lots of money or your GICs aren't paying anything, you probably are doing exactly the wrong thing. Investing when newspaper headlines are doom and gloom and the boys have been blown away would be a better timing strategy. At the peak, it's impossible to find a bearish forecast. At the bottom its impossible to see the upside.

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