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Advisor Roundtable: Does Market Timing Work?

By Jim Fink on August 13, 2010

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It is every investor’s dream to time the market.

Aswath Damodaran, NYU finance professor

Being able to time general market swings and industry sector rotations is fabulously profitable in theory but extremely hard to practice successfully. Just think about it: if you could time the short-term up and down movements of a broad-based index like the S&P 500, why waste time studying individual companies? All you would need to do is trade call and put options on the S&P 500 and make a fortune.

I am being flippant, of course, since there are varying degrees of market timing that could be applied to your investing. Even if you aren’t proficient enough to call short-term moves with any consistency, market timing could still be useful on a simpler, more individualistic, and longer-term basis. NYU finance professor Aswath Damodaran provides four classifications of market timing, from least complex/active to most complex/active:

  1. Asset Allocation — Alter your mix of stocks, commodities, bonds, and cash depending on your market view.
  2. Style Switching — Within your stock allocation, alter your mix of growth vs. value stocks, and large-caps vs. small caps.
  3. Sector Rotation – Within your stock allocation, alter your weighting of industry sectors. I wrote about this in How to Pick Industry Sectors.
  4. Speculation – Make short-term directional bets using leverage (e.g., options and futures).

While successful market timing is immensely profitable, the costs of being wrong can be equally devastating. A 2005 study by Michigan finance professor H. Nejat Seyhun concluded that missing even a few of the market’s highly profitable timeframes could really hurt your wealth:

The research confirms that market timing continues to be even more difficult and risky than many investors have been led to believe. The study illustrates how waiting to invest can cause one to miss the relatively few trading days when the market generates it highest returns — a narrow window of opportunity most individual investors are ill-equipped to anticipate.

But KCI’s stock analysts are not “most individual investors.” They have unique insight demonstrated by their market-beating returns. Furthermore, they are primarily fundamental investors who believe in wealth generation through long-term stock ownership. Market timing is utilized, if at all, sparingly “around the edges” as a return enhancement, not as an “all in” strategy.

With that in mind, I asked KCI’s investment experts the following question for this week’s Advisor Roundtable:

 Do You Believe in Market Timing?

 

None of the gurus advocated speculating on the direction of the overall market, although speculating on individual stocks was fair game for Stocks on the Run advisors Elliott Gue and Yiannis Mostrous. As hedge fund legend Paul Tudor Jones once said:

When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500.

Top-down investors Elliott and Yiannis had confidence they could add value with some or all of the market timing classifications numbered 1 through 3. In contrast, bottom-up value investors Roger Conrad and David Dittman were more likely to focus on businesses and dismiss market timing altogether.  Read on to find out the details:

Roger ConradUtility Forecaster, Canadian Edge, MLP Profits

I generally buy a stock for one reason: I like the underlying business and I believe the investment public is unduly pessimistic on its prospects. I sell when either the stock has run to what I consider extreme overvaluation, or when the underlying business is faltering.

My approach is decidedly bottom up, so I’m usually in the market. The lower prices go, the more bullish I get. The key is dividends. As long as the high yielding companies I favor can maintain or better increase their distributions, market history shows clearly they’ll recover from any spill in their share price. That’s precisely what happened following the crash of 2008, the worse confluence of credit, market and economic pressures in 80 years.

If I do follow any macro market indicator, it’s investor sentiment. Too much bullishness makes me very uneasy. Extreme fear and worry such as we have today are in my view pretty good assurance that whatever falls the market suffers will be a lot more benign and short-lived than 2008. Some will get their heads handed to them yet again by reacting too severely. But history shows us that major events never occur when so many people expect them. And those who look to buy the next time panic flares up will build fortunes.

Elliott Gue — Personal Finance, Energy Strategist, MLP Profits, Stocks on the Run

I generally have a top-down approach to the market. I start by evaluating general economic conditions both in the U.S. and abroad, followed by a look at trends in various industry groups and, finally, individual companies. Most of my recommendations are grounded in an analysis of fundamentals according to this basic structure.

Market timing is a rather broad term but I will take it to mean the use of charts and technical indicators to identify attractive market or sector entry points. On that definition, I do use timing to make buy and sell decisions, especially in Stocks on the Run where I and Yiannis are looking for shorter term “trades” rather than longer-term investments.

Every evening after the close I run a series of screens, looking for companies making big moves or moving on unusually heavy volume. I scan well over 100 charts every trading day, simply looking for sectors and stocks that are seeing increased attention or that appear to be trending. I then take a more detailed fundamental look at these firms; on many occasions these screens highlight trends I would have otherwise missed. When trading stocks, I look at charts to determine when to buy a stock and where to set stop losses.

I also keep tabs on the broader market indices like the S&P 500. I keep an eye on key support and resistance levels as well as moving averages. One useful and quick technical indicator that’s saved me a good deal of money over the years is simply to look at an index relative to its 200-day moving average. If the S&P is trading below its 200-day, as it has been recently, it pays to be more cautious when buying stocks.

Yiannis Mostrous — Silk Road Investor, Global ETF Profits, Stocks on the Run

Since my buy and sell decisions are part of running a portfolio, evaluating the timeliness of countries and industry sectors is a very important part of my investment discipline. I want my subscribers at Silk Road Investor to be in the best performing investments at all times.

I am a top-down investor. When deciding what to buy, I evaluate the state of the economy and forecast which industry sectors should benefit from the “next step” in economic developments.

With regards to my selling discipline, I run my evaluation process in reverse, looking to book profits in sectors whose investment themes have run their course and no longer enjoy economic tailwinds.

In regards to the market, when you run a long-only portfolio like Silk Road Investor, the best you can do is to let your subscribers know when they should take money off the table because you think the market has gotten ahead of itself and is about to turn down. I would never recommend selling the entire portfolio, however, for two reasons. First, there are always some stocks that buck the general market trend. Second, tax considerations could outweigh any short-term decline that I foresee.

Silk Road Investor subscribers know that we have been fairly accurate in calling some major market turns.

David Dittman – Canadian Edge

Back in April, when we first started doing advisor roundtables, I identified Roger Conrad as the investor who’s influenced me most during my career. Well, here’s some substance to that feeling.

As was noted in our piece on the Canadian oil sands this week, in the Canadian Edge portfolios and “How They Rate” tables you’ll find a CE Safety Rating for each company. The CE Safety Rating is an index based on seven criteria directly impacting dividend sustainability. These seven criteria form the basis of my analysis when I take a look at a stock.

Roger developed the CE Safety Rating system based on a similar system for Utility Forecaster, the UF Safety Rating System. These are simple, numbers-driven methodologies that help establish whether a particular investment fits within your risk tolerance and long-term objectives–and also provide a snapshot of the quality of the underlying business.

A high safety rating doesn’t always mean “buy,” nor does a low rating imply “sell.” The relative risk reflected in a company’s safety rating may or may not be priced into its stock. A perfect “7” (seven-for-seven on the safety rating criteria) may be overpriced. Likewise, though rarely, a company hitting two or even just one benchmark can still merit a “buy” in the advice column.

Some things are cheap for good reasons, others because they suffer for short-term or easily correctible flaws. You can lock in a compelling yield when the market overreacts to perceived risk, and you can overpay and crimp your long-term wealth-building, too.

Jim Fink – InvestingDaily.com

Legendary value investor Ben Graham once said:

In the short run, the market is a voting machine, but in the long run it is a weighing machine

What this means is that in the short run, prices are determined by human emotion whereas in the long run, they are determined by hard-core valuation. Market timing methods focused on the short run, consequently, must predict human emotion which is notoriously fickle and unscientific.

Consequently, short-term market timing based on objective valuation measures is doomed to fail. More than once I have tried shorting “overvalued” stocks and gotten my head handed to me. In the short term, one must use technical measures of supply and demand to understand the “voting machine” that is stock price performance. As I wrote in both Stocks on the Run and Mechanical Investing, there is academic evidence that price momentum has predictive power for future short-term price direction. As hedge fund manager Cliff Asness put it in an interview this past March:

Simply put, momentum investing is buying securities that are improving and selling securities that are deteriorating. There has been a mountain of research since the early 1990s showing that momentum “works” — meaning that price momentum has significant predictive power. Beyond this empirical evidence, there has also been considerable behavioral finance research to explain why trends tend to persist.

Although I am primarily a fundamental value investor, I use technical analysis for entry and exit points. In other words, I use fundamental analysis to select stocks to buy or short, but I use technical analysis to time my trades in these stocks. Specifically, I look at weekly charts, full stochastics, and the slope of exponential 50-day and 200-day moving averages to isolate positive and negative short-term trends.

Such momentum analysis does not work over long timeframes. Understanding the “weighing machine” behavior of long-term stock market performance requires fundamental valuation analysis. Consequently, the way I market time long-term investments is to isolate a stock’s intrinsic value and then wait for the inevitable short-term price fluctuations of the marketplace to permit me to buy the stock at a price below its intrinsic value.

With regard to the overall market, I have found that the Q ratio (business asset replacement cost) and the cyclically-adjusted 10-year average P/E ratio (CAPE) are good aggregate measures of the intrinsic value of the S&P 500. These measures are periodically updated on Andrew Smithers’ website.

As valuation measures, they do not provide short-term timing signals, but can help with long-term stock asset allocation decisions. In Smithers’ book Valuing Wall Street, he demonstrates that a trading strategy based on selling stocks when Q is 50% above average and then buying back in when Q reaches its average value significantly outperforms a buy-and-hold strategy.

Keep in mind, however, that Smither’s trading strategy can appear very wrong in the short-term. For example, it would have kept you out of stocks during the immensely profitable Internet bubble period of 1998 to 2000, so you need a steel discipline to follow it. But doesn’t long-term success always require discipline?

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KCI Investing has an incredible collection of top-notch investment minds covering all aspects of the stock, bond, international, and ETF marketplaces. Whether you are interested in growth, energy, utility income, Canadian income trusts, emerging markets, ETFs, master limited partnerships, or short-term trading opportunities, KCI has an investment expert and service ready to help guide you towards wealth accumulation and financial independence.

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