Market Timing – Oct 28 09

November 5, 2009

The appeal of market timing is almost too good to resist. Who wouldn’t want to have sold their equities (stocks) in early Sept of 2008 (high point) and bought in March of 2009 (low point)? We either feel we’ve missed a great opportunity or are upset because we feel we’ve lost something when comparing our statements over the last few years. Much of the media and many investment newsletters claim significant returns can be made by timing the market. The reality is, it is extremely difficult to market time consistently. No one has developed a consistent methodology for successfully timing markets that improves returns over holding a 100% equity portfolio over the long term.
If asked to name the greatest investors alive today or in history, you might name Benjamin Graham (Father of value investing), Warren Buffet (one of his students), Charles Brandes (Benjamin Graham’s stock broker) or Peter Lynch (manager of one of the largest and most successful mutual funds in history – Fidelities Magellan). None of these great investment managers were market timers – they were stock pickers. They would buy a stock when it was undervalued and then sell it when it was over valued and then buy something else. They focused on the valuation of the stock – not the market. Their track record of returns proves why they are held in such high esteem.
Try naming a well known “market timer”. There may be a few people that could come up with individuals who called one or two major stock market corrections – but not one market timer has been able to consistently call market declines or bear markets. The market crash in Oct of 1987 was called by Marc Faber (one of a few who guessed right) and he was able to “dine out” on that call for years. He continues to publish a newsletter “Gloom Boom and Doom” despite its relatively low rating for accuracy of predictions. Due to the appeal of market timing, calling just one major stock market decline correctly would be highly profitable to anyone. Media interviews and a successful book are a given.
Benjamin Graham developed an investment approach called “value investing” which is accepted and practiced by many investment managers and has withstood the test of over 60 years of market history. There is no similar “market timing” methodology as widely accepted – although many continue to propose they’ve found a method that works or “guarantees you can beat the market!” If there was a method that worked consistently, it would be taught to chartered financial analysts and they would be using it.
A U.S. advisor modeled a 50-50 stock and bond portfolio of US stocks going back to 1925 and compared it to an approach where he increased stock exposure when stocks were considered cheap and decreased stock exposure when stocks were considered expensive. The portfolio that was adjusted annually did do better than the straight 50/50 stock and bond portfolio, but it still didn’t do as well as an all stock portfolio! Adjusting allocations with market conditions will do better than a fixed allocation but riding through the ups and downs of the stock market seems to be the way to make the most returns in equities.
The article linked below analyzed the accuracy a market timer would have to achieve to better the returns of a portfolio fully invested in stocks. The analysis suggests a market timer would have to be right 74% of the time to do better than just staying fully invested. In other words make 3 out of 4 correct calls to beat a 100% fully invested stock portfolio.
http://www.quickmba.com/finance/invest/timing/
Although the evidence to the contrary, market timing will continue to be appealing for a number of reasons;
1 – Stock markets have experienced long periods of decline. Investors become anxious and impatient for returns to materialize. There have been approximately 5, 10 year periods where US stocks were flat to slightly negative since 1930, given the volatility of stock markets, anyone can pick a number of periods between stock market peaks and troughs where returns are negative. However, just holding on to the equities until the recovery occurred brought the returns back to positive numbers. We need to think about owning stocks as we do owning a house – despite temporary declines in both types of assets, we need a certain allocation to stocks in our portfolio for their growth and future income just like we need a home for its (tax free) growth and shelter.
2 – Avoiding pain is three times more important to us then experiencing pleasure. One of our most basic and necessary survival instincts is to avoid pain. No longer does famine or the saber tooth tiger represent danger – now it’s the stock market because of the financial security we need. We also see greater benefit to an immediate result than we do from long term results. Avoiding the immediate pain of a declining portfolio is more appealing than the long term financial security of that portfolio. In a world where the real risk is financial security, investors who recognize the long term benefits equities offer – and have designed portfolio’s with sufficient cash and bonds to protect against market declines, do not necessarily see a drop in market value as painful. They see it as an opportunity to purchase or rebalance into equities which will recover and provide significant returns in future.
3 – The belief that this time is different. Although 200 years of market history has proven stocks have recovered from declines and gone to higher peaks each and every time – there continues to be a believe that, “this time it’s different!”. Since none of the major market declines in the last 75 years previous to the one we experienced in the fall of 2008, have occurred during our investment life time, we feel that the one we are experiencing is somehow different from all the others. Stock market history tells us, although each market decline occurs for a different reason – all declines follow similar patterns. It’s the timing of these patterns which is different and cannot be predicted in advance.
Although market timing has not proven to be a consistently successful strategy there are strategies and tactics that have. We’ll discuss these in next months’ newsletter.