Timing your investment decision to buy low and sell high is much harder than it sounds.
Market timing may sound easy and straightforward. It can simply look like a bunch of strategies that involve moving between risky assets, such as stocks or bonds, and less risky short-term securities like Treasury Bills. Reduced to its core proposition, market timing means “buying low and selling high.”
On the other hand, 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 said after being wiped out in one of the many stock market crashes of his era in 1768:
“I can calculate the motions of the heavenly bodies but not the movements of the stock market”.
That’s a lesson being learned by most active investors since then. The price of long-term financial assets such as stocks or bonds involves all components of the human condition: fear, greed, optimism, pessimism, crowd psychology, etc. For good measure, politics, economics, revolution, natural disaster, and technology also get mixed in.
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 that no one could predict the market. They then set about proving this, hoping to make their insulated lives easier since they would never have to stick their necks out with market predictions.
For most investors though, the eventual reward from successful market timing is too attractive to let the idea passes by. If one could participate in all the +25% up years in the stock market and pass by the -25% down years by holding T-Bills 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 and avoid the downturns. Many market timers develop 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”.
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.
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’s the patterns alone that describe 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 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, the price of longer-term assets such as stocks and bonds fall as money and credit become scarcer.
Another fundamental measure would be the dividend yield on stocks, i.e. dividend divided by the stock price, in both absolute level and 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 indicates the stock market is expensive. When the dividend yield on stocks is low relative to bond yields, this generally means investors are willing to pay more for stocks relative to bonds than has been the case historically.
Quantitative techniques involve associating different market measures or “variables” in quantitative equations or “models”. For example, an analyst might “build a model” that relates the movements in stock prices to money supply, dividend yields, and economic activity. From this, he would attempt to identify 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.
Is it possible to establish a valuation level for the markets, similar to stocks? Let’s say a small company has very few competitors, well known product line and management, and cashflows that can be identified and assessed. Whereas we can assign a value to this company, its stock might not be appropriately valued for years with its future prospects dependent on the economy in general. Now assume we are to assign a valuation to a market, there are tough questions we may need to comprehend: 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 identify “extremes,” or times 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 market crash 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 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, the 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 actually 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.