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.

As can be seen in the table below, the results varied significantly. I'm not intimately familiar with the details of their respective strategies, but we can make a few observations based on their results.

First, obviously their systems are quite different to have generated such different outcomes. The Hulbert Financial Digest reports that Brinker moves in and out of the market relatively rarely for a timer, and, surprisingly, stayed fully invested throughout the recent 2007-2009 bear market. It seems apparent that Brinker doesn't use a trend-following system.

Doug Fabian was somewhat more active, averaging almost six complete moves a year (three to get out, three to get back in). It didn't help, as he turned in the worst overall performance of the three. Still, it must be said that he did turn in results better than the -0.8% annual loss the market offered. Timer Digest was the winner among the three, doing almost as well as the SMI Upgrading strategy. Their strategy averaged 12 complete moves a year (six exits, six re-entries).

The 10-year data doesn't tell the whole story. Many investors find value in timing strategies because of the protection they attempt to offer during bear markets, not for their overall long-term performance. The fact that Fabian and Timer Digest did a pretty good job of preserving capital during 2008 could be the deciding factor for many risk-averse investors. Potential downside protection, not long-term performance, is the basic attraction of a market-timing strategy.

OTHER CONSIDERATIONS

Let's assume that you have arrived at a structured set of rules that will tell you when to sell, and just as importantly, when to reverse course and reinvest in stocks. Or, perhaps you've decided to subscribe to Timer Digest and follow their rules. Also, we'll assume you have complete confidence in the system you're using. That's a big mountain to climb, but let's say you've done it. What else needs to be decided? Here's a partial list.

1. How much of your money are you going to move at one time? Some investors prefer to move it all at once so that they are either completely in the stock funds or completely in the money fund. That way they never have mixed feelings about what they are looking and hoping for. Others prefer to make changes piecemeal, using different systems to control each piece. This spreads the risk and reduces the need for any one decision to be correct.

2. Are taxes a consideration? Every time you sell a stock fund, a capital gain or loss takes place for tax purposes. Also if you buy a fund just prior to its making a capital gains distribution, you incur tax liability for gains earned by other shareholders before you came along. Are you going to try to factor these considerations into your timing and choice of funds?

3. Do you have the time needed to follow the market? It can take a great deal of time to properly execute a market-timing program. Even with the use of a market-timing newsletter, you still need to faithfully read the emails for current information and act promptly when instructions are given. It may not sound like it, but this is actually the hardest part.

MOVING FROM THEORY INTO REAL LIFE SITUATIONS

Because "buying low and selling high" is every investor's dream, market timing can sound an alluring call. But is it just another investing fantasy?

Superstar investors such as Warren Buffett don't even attempt it. The Harvard Business Review called it "folly," and Money magazine frequently ridicules it. Many knowledgeable investing folks are lined up against it. They say it's too difficult to be done on a consistently profitable basis, and that newsletter writers have grossly exaggerated its value to sell more newsletters. While it sounds good in theory, they submit it doesn't deliver as advertised.

It's been my experience that market timing can improve returns; however, (1) it's not as easy as some would have you believe and (2) it's mentally and emotionally exhausting. I gained this insight the old-fashioned way — I earned it.

In 1978, a close friend and I decided to launch an investment advisory service based solely on market timing. We were one of the early entries in what eventually became a crowded field. During periods of market weakness, we performed exceedingly well for our clients due to our ability to sell out and move quickly into money market funds. When the eventual rallies occurred, we were nimble enough to get back in and enjoy most (but not all) of the ride up. Our strategy generated returns which saw our average managed account more than triple in value during our first five years of operations.

Our "glory days" faded during the bull market of the mid-1980s. Market timing doesn't work well in bull markets because the occasional moves out of the market eventually prove unnecessary, and you often find yourself buying back in at higher prices. Clients become impatient with these miscues; during bull markets they forget the need to be ready with a defensive game plan.

The summer of 1987 still stands out in my memory as one of the worst periods of my professional life. In April of that year, we sold all stock funds and placed our clients 100% into money market funds. We did this because we felt the market had risen too far, too fast. In our view, the environment had become a very high risk one. As the Dow continued to rise over the summer months (and everybody just "knew" it was going to continue setting new highs), we began losing clients to other firms who had no such reservations about risk.

Our warnings to our departing clients fell on deaf ears. I'm sure many felt we were out of touch with the "new realities" of the market. In truth, they and their new money managers were the ones out of touch, as the October '87 crash violently demonstrated. In a single day that came to be known as Black Monday, the Dow Jones dropped almost 23% (about 2,400 points in today's prices), and it didn't recover to its former level for two years. The crash vindicated our caution, but only after great damage was done to the size of our client base.

BEDEVILED BY FEAR AND GREED

Successful market timing demands enormous self-control, more than most people are conditioned to give. That's why I never recommend that average investors attempt a market timing strategy on their own. It's just too challenging emotionally.

First, there's our natural greed. Peering blind-eyed into an impenetrable future, we talk ourselves into expecting the best. So if our trade turns into a loss and our timing system says to sell, we tend to hope, Surely the market won't go straight down from here. There's bound to be at least a little bounce and I can get out without a loss. How many times have you decided to sell an investment "just as soon as the price gets back up to what I paid for it?"

Second, there's simple fear. Your system says, "Buy" — but you're convinced by what you've been reading and hearing in the news to expect further weakness instead. This causes you to lack confidence in your system's signal. You decide that if the market can prove itself by rising to Point X, then you'll buy. When Point X is reached, you feel better about the market's prospects, but don't want to pay the higher price.

Your plan becomes, "I'll buy on a pullback to Point Y." Assume you are given this second chance and Point Y is reached. Perversely, the very weakness that you were hoping for now causes you to doubt the authenticity of the rally. You again hesitate. While you're racked with indecision, the market roars off without looking back. When last seen, you were still trying to muster the courage to get invested.

Both of these stories reflect an enormously powerful influence felt by every investor: "the fear of regret." This is particularly powerful around Wall Street because the trading prices of stocks are quoted every business day.

This isn't true of many other types of investments. Take real estate, for instance. You may have a vague idea of the long-term ups and downs in the market value of your home, but you can't get a precise fix on it. This lack of information actually provides you with emotional protection. It buffers you.

But if you own stocks, you can pick up the newspaper and find out to the penny the price for any actively traded stock you have ever owned. A week, month, or year after you've cashed out, you can, if you wish, torment yourself by looking to see if your stock continued to climb without you. Investors are always doing that and working themselves into a frenzy of regret over it.

This depressing experience happens to every investor occasionally. And the fear of it happening again can cause you to delay acting next time around.

THE VOICE OF EXPERIENCE

Professional market timer Paul Merriman, who's been dealing with the challenges of market timing for his clients for more than 30 years, points out some of the realities of life as a market timer:

To be a successful investor, you need a long-term perspective and the ability to ignore short-term movements as essentially "noise." This may be relatively easy for buy-and-hold investors. But market timing will require you to focus on the short term.

You'll not only have to track short-term movements, you'll have to act on them. And then you'll have to immediately ignore all unsatisfactory outcomes. Sometimes that's not easy, believe me.

You have to always be ready to take action. This can be tough to do. Also, you will have long periods when you will underperform the market. It's common for timers to be in the market when it's going down and out of the market when it's going up.

Most would step forward at this point and say, "I probably don't have what it takes. It's unrealistic for me to try to time the market." But what then is the motivation, conscious or subconscious, behind the most common questions investors ask, such as: When will the rise in interest rates begin? Where is the market headed next? Should I buy growth stocks now? These are the questions the financial media constantly raise, appealing to our natural desire to make profitable decisions. Yet, they are largely irrelevant to the investor with his eyes fixed on a distant horizon.

The long-term investor is asking a different set of questions: Is it even appropriate for me to take on the risks of investing in securities that fluctuate in value? If so, how should I divide my capital between the different kinds of investments (stocks, bonds, real estate, etc.)? What are the growth prospects for the next ten years, both in America and various overseas economies? Am I getting good value for my money?

Despite bountiful evidence of its difficulty, millions of investors are closet market-timers. They expect to be able to select the cream of the investment crop, ride their holdings to the crest of a glorious bull market, and then wisely take their profits. They'll move to the sidelines and let other (presumably less savvy) investors suffer the frustrations of the inevitable correction that follows. Unfortunately, this is a fantasy.

We need to say, along with the apostle Paul, "When I was a child, I talked like a child, I thought like a child, I reasoned like a child. When I became a man, I put childish ways behind me" (1 Corinthians 13:11). To be profitable, we need to put away childish things — such as demanding immediate gratification — and invest by using our reason rather than our emotions.

THE KEY TO SUCCESS

The key to success is in being faithful, not in timing systems. Self-discipline is the ability to do the right thing at the right time every time. By the "right" thing, I don't mean always making the most profitable decision. That's impossible. Rather, I mean the right thing is to ignore the distractions of news events and well-intentioned advice and stay with your plan.

This is more difficult than it sounds because the markets don't always offer positive reinforcement. In the short run, you can lose money following your plan or you can make money deviating from it. When that happens, "good" behavior is penalized and "bad" behavior is rewarded. It weakens your commitment to following your strategy.

If this continues, it isn't long before you're back where you started — making every decision on a what-seems-best-at-the-moment basis. Unless you have a rare and natural gift for investing, that's the last place you want to be.

Even conservative strategies require self-discipline. To follow our Four Levels approach, to build a portfolio based on your emotional temperament, to stay with our fund selection and extensive diversification recommendations, all this requires self-discipline. The payoff is a conservative, workable strategy built around your specific, personal situation. It fosters a long-term perspective. It's easy to understand and takes little time to implement.

Based on my 40+ years of investing experience, I've no doubt this approach, rather than the elusive promises of market timing, is the best long-term strategy for most investors.

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a Realtor® in the area.

• Facing Your Fears: What If We Have A Market Like We Had During The Great Depression?
• Trusting God to Work Things Together for Good
• Market Probabilities: What the Past Suggests About the Future
• Investing Wisdom From a Master

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