If you were to mention the word market timing in an innocuous discussion with your broker, financial advisor, or friends, you shouldn’t be sur prised to see the conversation go downhill from there. Consider that probably 99.9 percent of the Wall Street professionals will tell you out right that market timing does not work, period. If you were to ask these people why they feel that way, they might cite a few academic studies performed a few years ago that have brought them to that conclusion. Or they might cite statistics from Ibottson Associates showing that over every 20-year rolling time period, the market has never gone down. Keep in mind what Aaron Levenstein said: “Statistics are like bikinis. What they reveal is suggestive, but what they conceal is vital.” Even if this were true, you can’t wait for five years or more to finally see your money come back from bear market lows. Long-term results cannot help you to invest for the here and now, which is when you need to see your money grow.
WHAT IS MARKET TIMING?
In general, market timing is an investing or trading strategy that looks to be invested in the stock market when it is advancing and to be in cash and/or to be short when the market is declining. This definition applies to investing or trading in any investment vehicle, such as individual stocks, mutual funds, exchange-traded funds (ETFs), options, futures, gold, or bonds. Many individuals and professionals who use market timing focus on the two mutual-fund families (Rydex and ProFunds) and three ETF familes (Rydex, ProShares, and Direxion) geared specifically to market-timers as their timing vehicles.
The three main objectives of market timing are
- To preserve capital
- To avoid large market declines
- To equal or exceed the performance of a buy-and-hold portfolio on a risk-adjusted basis
The whole concept depends on limiting the risk when the market begins to decline by being defensive. Picture this: If you were in a leaking boat you’d have three choices:
- Stay in the boat and stop the leak Go short.
- Get out of the boat Switch to cash.
- Go down with the ship Buy-and-hold.
Do I have to ask you which is the worst choice? It’s really easy to understand. What’s not so easy is to execute the strategy. But we’ll get to that later on.
A buy-and-hold approach in equities exposes 100 percent of the invested dollars to market risk. If an investor purchases an ETF for $50 a share, uses a buy-and-hold strategy, and then watches as the share price falls to $5 over a three-year time frame, the investor has lost 90 percent of his or her money. A market timing approach would have gotten the investor out of the ETF at a much higher price and placed the proceeds of the sale in a money-market fund or T-bill during the downdraft. Thus the risk is reduced because the time invested in the ETF is reduced. This is what timing is all about—reducing your risk.
As we know from experience, bear markets intercede every three to six years and cause investors to experience portfolio deterioration. An analysis of the Dow Jones Industrial Average (DJIA) from 1885 through 1993 found that bear mar kets consumed 32 percent of the investment timeline, getting back to breakeven took another 44 percent of the timeline, and only 24 percent of the timeline was spent in net bull territory.1 This is the problem with buyand- hold—long periods of negative or zero returns. And we haven’t even factored in the opportunity cost of funds or the ravages of inflation, which are admittedly low in 2010.
There are two types of professional market-timers: the classic market- timers and the dynamic asset allocators. The former usually invest in mutual funds or ETFs as their investment vehicles, and they move their money into a money-market fund or T-bills when they are not invested in the market. A clas sic market-timer may decide to go from a cash position to a 100 percent invested position or possibly to a 25 percent invested position, in 25 percent increments, until fully invested based on a particu lar timing strategy. And he or she may decide to exit the same way, by selling 25 percent of the investment, in 25 percent increments. Also, some classic market-timers may go short instead of going into cash to take full advantage of a market decline. The market-timers who go short the market may use leveraged mutual funds such as Rydex Titan 500 and Rydex Tempest 500 to go 200 percent (because of the leverage) long the Standard & Poor’s (S&P) 500 Index or 200 percent short the S&P 500 Index, respectively. Or they may use unleveraged funds (such as Rydex OTC Fund and Rydex Arktos) to go long the Nasdaq 100 Index or to go short the Nasdaq 100 Index, respectively. They also can use equivalent leveraged ETFs from Direxion, ProShares, and Rydex SGI funds.
DYNAMIC ASSET ALLOCATORS
Dynamic asset allocators, unlike classic market-timers, are typically 100 percent invested in multiple asset classes, but they may spread their investments among ETFs, stocks, bonds, gold, alternative investments, and cash in varying percentages. They either invest directly in those instruments or they use index mutual funds, sector mutual funds, leveraged mutual funds, or ETFs that represent these asset classes. For the investors who prefer to always be invested with wide diversification, the asset-allocation approach fits the bill nicely. And typically, the overall risk of the portfolio is less than that of investing in one specific investment vehicle such as equities.
TIMING METHODS AND BENCHMARKS
Numerous methods are available to time the market. Typically, professional market-timers have developed strategies based on technical indi cators aimed at price, volume, sentiment, or other variables to develop their timing models. Some professional timers disclose their model logic to their clients, whereas others keep it proprietary. Some market-timers use very simple market timing models (e.g., the 200-day moving average), whereas others may use multiple indicators. The main concern is how well the market timing strategy has performed against an appropriate benchmark and the amount of portfolio risk encountered, as measured by the standard deviation (volatility from the average price) or “ulcer index” (i.e., a measure of pain). For example, if a timer is investing in the XLK (the S&P Technology SPDR ETF), then the appropriate benchmark is the Nasdaq 100 Index.
The appropriate benchmark for dynamic asset allocators is more complicated than that for classic market-timers because the timers may invest in multiple asset classes. In such a situation, the bench mark should be a weighted average of individual benchmarks based on the asset allocation of the portfolio. For example, a port folio composed of 25 percent equity large-cap mutual funds, 25 per cent intermediate bond funds, and 50 percent gold funds would use three different benchmarks appropriately weighted to provide the composite benchmark.
PERSONALITY CHARACTERISTICS OF PROFITABLE MARKET-TIMERS
You don’t have to experience fear and greed over the inevitable and numerous market roller-coaster rides. Market timing can help you to develop a rational, time-tested, less risky investment methodology that will allow you to sleep at night and not worry about what tomorrow’s news will bring. Is market timing perfect? Are you perfect? Of course not. No one in the market is perfect. However, by putting the odds in your favor, you can enhance your returns and minimize your losses. In the end, you will have more money in your pocket and be savvier than 98 percent of all investors who ignore reality and ride the emotional roller-coaster year in and year out.
The odds of using a market timing approach successfully depend greatly on your personal ity traits. If you are impatient, cannot stand to lose any money, expect perfection with regard to your timing system, or are always looking to change the way you invest (looking for the Holy Grail), then self-directed market timing will not work for you. The following are the per sonality traits necessary to have a solid chance at being a profitable self-directed market-timer:
- Patience, determination, perseverance, and discipline. Timing the market requires patience and discipline because you cannot afford to accept some of the timing signals and ignore others and you never know in advance which signals will lead to the most profitable trades. You must be able to sit tight and obey the timing signals after they are given, even though the mar ket may go against you initially. You must have discipline to follow your timing rules, and you must be determined to let your timing system have sufficient time to work its wonders. Markettimers who persevere are the ones who survive.
- Self-confidence. If you believe in the market timing approach that you’ve selected and you’re able to feel comfortable using that method, then you are better able to stay the course. Having a strong self-image and having your ego under control are critically important characteristics that lend themselves to a successful market timing outcome.
- Independent thinker. You must be able to think for yourself and not be swayed by your financial advisor, broker, friends, family, or popular opinion. You need to turn a deaf ear to all that noise and concentrate on your selected investment approach.
- Realist. Your market timing system will not beat the buyand- hold strategy every year, especially during multiyear bull runs. This is why you need to give your timing strategy years to work. Using it for six months and then chucking it out the window is not the way. Moreover, you may feel concerned that only 40 to 50 percent of your trades are profitable. This is not a problem as long as the profits on your winning trades exceed the losses on your losing trading by at least a factor of 2 to 1. Moreover, you may experience runs of three to four losses in a row, and once in a while, you may have 14 losses out of 15 trades. Such an outcome can happen, but hopefully, it is rare, if ever.
- Quick decision maker. You must execute the timing signals quickly when they are triggered. This means that you need to act on every buy-and-sell signal with your investment vehicle the day the signal is given. At the very latest, you need to act by the next day if you cannot watch the market and anticipate the signal when it is close to triggering. If you question every signal for emotional reasons or because of extraneous outside influences (e.g., CNBC commentary, Fed meeting announcement, or unemployment report release), then you will not achieve satisfactory returns. If you rationalize your decision not to honor your signals or say that this time will be different, then you have compromised your timing system, and it won’t work for you.
- Emotionally stable. If you are bothered by little things, are emotional about everything, hate to be wrong, and waver in dealings with people, then market timing will not suit your personality. A calm, self-controlled, emotionally stable personality is what you need to succeed. You cannot let your emotions enter the investing equation; otherwise, you will negate the benefit of using nonemotional, mechanical timing methods.
SIX KEY FACTS ABOUT MARKET TIMING
You should understand the following facts about market timing.
Market Timing Has Nothing to Do with Forecasting the Market’s Future Direction
Samuel Goldwyn once said, “Never make forecasts, especially about the future.” What you are trying to accomplish with market timing is to equal or exceed the buy-and-hold strategy’s returns with much less risk while protecting your principal from erosion above all else. Just because you received a market timing buy or sell signal does not mean that the market will continue in that direc tion for an extended period of time. Nor does it mean that the signal will be successful all the time. Market timing has to do with putting the odds in your favor over multiple bull and bear market cycles. Overall, you will have satisfactory or better results without having to guess where the market is going. Your signals will tell you when to buy and when to sell. That’s all you need to know. Don’t listen to investment gurus, the vast majority of whom have been completely wrong in their calls on the market. Consider a Barron’s article about stock market forecasting. Ten well-known market strategists from leading firms were interviewed by Barron’s and were asked for their market predictions for the upcoming year. Nine of the 10 predicted a rising market and were proved wrong. And only one predicted a drop, but he was off by 75 points on the S&P 500. He predicted a close of 950 on the S&P 500, but it actually closed at 875.
Market Timing Assumes that Stock Prices Are Not Random and that the Stock Market Is Not Efficient
These anomalies allow market-timers to take advantage of trends in the market. Of course, academicians have written extensively about the random nature of stock prices and the efficient-market hypothesis. In the practical world of professional investment management, however, academic theories are just that—academic theories that cannot usually be substantiated by what goes on in actual practice.
Market Timing Should Be a Mechanical, Emotionless, and Boring Approach to Investing
Once you’ve decided to use a specific strategy that fits your personality, take all the signals, and monitor your performance. Once a signal is given, take it, and then get ready for the next one. If the last trade was a loss, so be it. Cut your losses short, and let your profits run. Small losses are good. But large losses are the killers. Ask anyone who stood pat with their investments from late 2007 to March 2009 how they would rate their investment skills. The answers would not be printable!
Unfortunately, most investors don’t know when to sell, don’t cut their losses short, and don’t use a target price. An investor needs to set a fixed exit price (e.g., a fixed percent, such as 10 percent below his or her pur chase price) to limit losses, and he or she needs to honor that exit price impeccably in the same way he or she honors his or her father and mother. Investors who don’t use stoploss or stop-limit orders to limit their losses and investors who are more worried about paying taxes on their gains than protecting their principal are asking for trouble, and sooner rather than later, they will find it. These shortcomings are mostly psychological in nature because taking a loss is basically admitting to yourself that your judgment was wrong and that you failed as an investor. Another common problem is that everyone is looking to get back to breakeven after a loss. If you bought Lucent at 70 and you still held onto it when it dropped by 99 percent, then you have emotional problems that you have to overcome. No market timing strategy is going to help you unless you rid yourself of your psychological baggage.
With Market Timing, You Will Underperform in a Sustained Bull Market
This outcome is to be expected because there may be periodic sell signals in an uptrending market to take profits because the market is overbought. By using market timing, though, you will hit the gravy train in bear markets.
Market Timing Provides the Buy and Sell Signals to Tell You When to Go Long and When to Go Short on the Market
You should understand that going short the market is the exact opposite of going long. Either strategy has the same risk as long as you have the same tight exit rules for each one. With the availability of long and short (inverse) mutual funds such as the Rydex SGI funds family and ProFunds, as well as their ETF counterparts, you can easily go long or short the market without the need for margin. This is certainly a very useful alternative in self-directed retirement accounts.
Market Timing Is Not Magic, Is Not 100 Percent Accurate, and Is Not for Everyone
The market timing strategies that will be presented in later chapters have all worked in the past, some better than others. They are all based on simple strategies, not complicated mathematical equations with numerous variables. Hopefully, they will continue to work in the future, but there is no guarantee that they will. Be aware that a strategy may be profitable less than 50 percent of the time and still be profitable overall. Market timing requires the critical characteristics mentioned earlier. Many individual investors do not possess them and therefore should not be self-directed market- timers. For those individuals, a market timing newsletter or timing service may be more appropriate.
Market-Timers Have Succeeded in Beating Buy-and-Hold
There are market-timers and market timing advisors who have beaten buy-and-hold on a risk-adjusted basis for the last 10-year period and during subperiods within it, as Chapter 12 details. In that chapter there is documentation from the Hulbert Financial Digest, TimerTrac, and Timer Digest on timers who have beaten their benchmark. Table 12-1 indicates the performance of the top timers as measured by Timer Digest for the last 10 years and earlier time frames. During the past ten-, eight- five-, three-, and one-year periods, all 10 “Top Timers” beat the S&P 500 bench mark. So much for the critics of market timing who say with a straight face that it does not work. They don’t want to be confronted with the facts.
BEWARE OF THOSE KNOCKING MARKET TIMING
I caution you not to believe anything you hear or read about investing from anyone unless the statement is proven to you with verifiable facts and figures. Keep in mind the following statement Jonathan Clements made in his book, 25 Myths You’ve Got to Avoid If You Want to Manage Your Money Right: The New Rules for Financial Success (Simon & Schuster, 1999):
Nobody on Wall Street has a monopoly on truth. Market strategists don’t. Money managers and investment newsletter writers don’t. Brokers, financial planners and insurance agents don’t. Newspaper columnists don’t. So treat all financial advice with caution. Look at every investment and every investment strategy with profound skepticism. Think long and hard about every financial myth. If you do that, you will do just fine.
Financial con artists like Bernard Madoff have been known to misrepresent the true statistics on their performance records. The Hulbert Financial Digest provides the annualized return of many investment newsletters, as well as their buy and sell dates and total risk-adjusted perfor mance. Many advertisements you see on television, on the Internet, or in print embellish or distort the truth in a dishonest attempt to gain your business. Don’t trust anyone with out first checking the claims and promises against the actual performance, their references, and the Better Business Bureau.
MERRILL LYNCH CONSIDERS MARKET TIMING USELESS
Consider the full-page advertisement in the November 10, 1998, issue of the Wall Street Journal sponsored by Merrill Lynch. Here is the headline, which takes up one-third of the page: “Timing Is Nothing.”
The ad goes on to say:
For as long as there have been mar kets, investors have tried to time them—to predict the precise moment when a down market turns upward or the legs give out on a bull. Sometimes it’s hubris, sometimes it’s fear: watching their investments fall, even seasoned investors can lose faith in the mar kets and, in a moment of panic, sell.
I’ll leave it up to you to decide if Merrill Lynch did well by its individual investors since this ad was printed. I think the company missed the point that timing is everything, especially with regard to investments.
Market timing has long been a controversial subject, with strong views expressed on both sides of the argument. After the severe beat ing buy-and-hold investors have encountered in the past decade, I believe that there will be more and more individuals, financial advisors, stock brokers, and institutions using market timing because it reduces risk, protects prin cipal, and is a conservative strategy. In contrast, even with diversifi cation, buy-and-hold is a highrisk strategy, as many investors unfortunately have discovered.