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.
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 cashflows 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. |