Market timing is one of the more controversial investment topics. On the one hand financial advisors frequently say it’s a bad idea. On the other hand, the financial media and analysts seem to continuously encourage it. In this article, we consider whether investors can in fact time the stock market. We also look at a few of the ways in which elements of market timing can be applied to a long-term investment strategy.
- What is market timing?
- Buy-and-hold investing vs. market timing
- Is it actually possible to time the stock market?
- Taking advantage of overreactions and irrationalities
- Market timing examples
- Risks of market timing
- Best practices for market timing
What is market timing?
Market timers attempt to outperform the market by selling at market tops and buying at market bottoms. This is in direct contrast to buy and hold investing which implies holding a portfolio through corrections and bear markets. Market timing usually involves fundamental or technical analysis, and frequently both. Predicting major market tops usually also involves economic analysis and assessing central bank policy.
Active investing, stock picking, and tactical asset allocation can all have elements of market timing to them. In theory market timing makes a lot of sense. In practice, it depends on an investors ability to buy and sell stock at the right time. It’s quite possible for market timers to end up with lower returns than they would have generated by simply staying invested.
Stock prices are very difficult to predict over the short term. However, over the long term there is some justification for using some timing strategies when managing a portfolio. For example, even if market timing results in lower returns it can be justified if a stock market crash is avoided.
Buy-and-hold investing vs. market timing
Like any investing strategy, buy and hold investing has its pros and cons. A passive approach is usually less stressful and requires less work. There is also less opportunity for emotion to affect decisions. Holding an ETF that tracks an index like the S&P 500 ensures that you hold the largest companies in the market. It also ensures that you will have exposure to the growth of any company that becomes a prominent member of the index.
Although the average annual returns for an index are quite modest, they do add up due to compounding. Just like compound interest leads to far greater effective interest rates over time, modest returns when compounded can result in massive overall returns. If you compound $1,000 at 10% a year for 20 years, you will end up with $6,272. This is a total return of 573%, or 29% a year.
The major weakness with buy and hold investing with individual shares is that you will usually find out too late when you are wrong. With indices, markets sometimes trade sideways for years at a time. During these periods only actively managed funds can generate returns.
Passive investing in an index fund implies that you are accepting that you will have no chance of outperforming that index. Using a buy and hold investment strategy to invest in individual stocks is a little different, as is illustrated by Warren Buffett’s investing style.
Warren Buffett is famous for value investing, and for holding stocks indefinitely. The aspect of his success that is often overlooked, is how good his stock picking is. His most famous investments are companies that have gone on to steadily compound earnings for decades. The fact that he bought them at a discount is just a bonus. If you can pick stocks that keep growing for a very long time, it makes sense to hold them. The reality unfortunately is that most companies eventually stagnate, and growth slows to low single digits.
The obvious advantage of market timing is that you can have less exposure when a large decline occurs. That means you avoid losses and you then get to buy more stock at cheaper prices. Sometimes equities, or any other asset, can remain in a structural bear market for a long time. An example is the S&P 500 which took seven years to regain its 2000 high, and then declined to below its 2003 low. Anyone who invested at the height of the dotcom bubble really only started making money again in 2013.
For buy and hold investors who invested in the Nikkei 225 index in the late 1980s, the result has been even worse. Nearly 30 years after the index peaked in 1990 it is still 38% below that level. Market timers who got that call right avoided losses as high as 80%. The problem is that doing this is easier said than done. Market pundits are well known for getting their calls wrong more than they get them right.
Managing risk by buying and selling your entire portfolio is itself very risky. Essentially, you are putting all your eggs in one basket. There are however other ways to manage portfolio risk without such a binary outcome.
Is it actually possible to time the stock market?
If professional portfolio managers struggle to time the market, what chance does the average investor have? The stock market is a very complex system of relationships and feedback loops. There really is no holy grail that allows anyone to predict where it will go next. Furthermore, a market timer must get not one but two things right. Selling at the right time isn’t good enough. You also need to re-enter the market at the right time.
Let’s say you expect a correction of 15-20%. You sell at exactly the right time and wait to buy the market 12-14% lower. But you find the market only falls 10% before rallying back up to make a new high. You are now in a worse position than you were to start with, despite selling at exactly the right time. This is a common problem with the Sell in May axiom. Investors often get the selling bit right, but then miss out on the next rally.
Whether or not it’s possible to time the market is difficult to say. A certain amount of skill is certainly required. There are also not that many opportunities to test this skill, meaning it can take decades to know how good you are. Realistically, investors don’t have decades to hone their skill and then put it to work.
Taking advantage of overreactions and irrationalities
While timing the market is both difficult and risky, it doesn’t mean you shouldn’t take advantage of opportunities offered by the market. Taking advantage of occasional opportunities in the market is not necessarily the same as timing the market. The price movements of stocks are driven by emotion as much as by rational analysis. When volatility increases, emotion and sentiment play an even bigger role.
Prices trade too high when investors are fearful of missing out, and they trade too low when investors fear losing money. This can create opportunities for patient investors with a systematic strategy. A timing strategy can use valuation analysis or technical analysis to identify attractive or overbought stock prices.
You can reduce portfolio risk when valuations are stretched, or prices are very overbought. You can do this by short selling futures or CFDs on a market index, or by hedging with put options. In this case, your motivation should be to take advantage of high prices rather than predicting a correction.
Market timing examples
The following are examples of different types of market timing strategies. The first three can be easily implemented by retail investors. The last two require significant resources and experience.
- Technical Oscillators
- Valuation Analysis
- Tactical Asset Allocation
- Market Sentiment
- Quantitative Investing
Technical Oscillators
Technical oscillators and price bands on weekly charts can be used to identify extreme price levels. By looking at the historical levels of oscillators like the RSI (Relative Strength Index) and Stochastic Oscillator you can find the levels that indicate very overbought or oversold conditions.
If the price reaches an extreme, but remains within a trading range or trend channel, there is a very good chance it will revert to the mean. You can also use these indicators in conjunction with volatility bands like Bollinger Bands. These will indicate whether the price is still within the “normal range”. This method is certainly not foolproof and stop losses should be used if the range or channel is breached.
Valuation Analysis
Historical valuations can be used for cyclical and mature companies. For these types of companies, a PE ratio chart will usually oscillate within a range of values. These levels can be used to add or reduce exposure to a stock, provided the underlying business model remains valid.
Valuation analysis can also be applied to ETF investing. The aggregate PE ratio for sectors and countries can be compared to their historical ranges. In this way capital can be rotated into undervalued ETFs and out of overvalued funds. This strategy works well when combined with momentum or trend indicators. The goal is to buy cheap funds with rising prices and sell expensive funds with declining prices.
Tactical Asset Allocation
Tactical asset allocation makes changes to the long-term asset allocation of a portfolio to take advantage of temporary opportunities. If the fundamental drivers of an asset class suddenly improve or deteriorate, the capital allocated to that asset class can be increased or decreased. An allocation will seldom be changed by more than 30%. In other words, if the long-term allocation to bonds is 15%, it would remain between 10 and 20%.
Market Sentiment
Market sentiment is increasingly being used as tool to time investment decisions. Extreme sentiment can be used as a contra-indicator. Changes in sentiment can also be used to confirm trend changes.
Lehner Investment’s hedge funds use AI and market sentiment to identify trades opportunistically. The Data Intelligence Fund uses market sentiment to identify profitable opportunities in the European equity market. Long and short positions in the Dax Future (FDAX) are implemented for exposure management.
Quantitative Investing
Some of the more active quantitative investing strategies are essentially market timing strategies. These types of systems can operate over very short timeframes, or to implement long term positions. Algorithmic trading strategies often combine diverse types of information to identify profitable trades. Metrics like sentiment, correlation, momentum, relative strength and investment factors can all be combined to identify opportunities.
Risks of market timing
The biggest risk with market timing is that of missing out on positive returns after exposure has been reduced. Research has shown that “time in the market” is usually more important than the ability to pick tops and bottoms. The consequences of getting a timing call wrong should always be considered.
In some cases, there may be tax implications if short term profits are generated by a tactical trade. If you sell a long term holding, you may have to pay capital gains tax too. Sometimes, losses can be used to offset gains, but this isn’t always possible. The tax implications of any significant decisions should be considered. When developing systematic market timing strategies there is a real risk of over optimization. This occurs when a strategy is adjusted to perfectly fit historical data. A system that has been curve fitted is unlikely to perform as well in the future.
Best practices for market timing
The most important thing with any market timing strategy is to be realistic. No matter how confident you are of a call, there is a chance you will be wrong.
The extent to which timing can be applied can vary widely. An entire portfolio may be sold in anticipation of a stock market crash. At the other extreme, the size of individual holdings can be adjusted to take advantage of market strength or weakness. If you do not have a lot of investing experience, you should tend to the latter approach.
Timing strategies should be used sparingly, to take advantage of the most attractive opportunities. Ideally, these trades should have a favorable reward to risk ratio, so that losses are justified. You should also have an exit strategy, so that you know what to do if you get it wrong.
Market sentiment can be a good guide for buy and sell decisions. You should be looking for extremely bullish or bearish sentiment, as well as sentiment shifts from positive to negative and vice versa.
Conclusion
Market timing based on predications of major bull markets, corrections and black swan events is a hit and miss affair. Some people do have a very good track record, while many have predicted events that never happened. This doesn’t mean you shouldn’t take advantage when the market becomes irrational and overreacts to news and events.
The best opportunities are created when other investors make mistakes. These mistakes are usually made when volatility rises, and decisions become emotional. You can take advantage of these opportunities with a systematic and sensible strategy.
