Timing the Market

To be, or not to be (in the market)

There is no shortage of strongly held opinions about timing the market. Broadly speaking, market timing is forecasting where the market is headed and taking a position based on that forecast.

The most common form of market timing alternates between being long in the market and being in cash. Being long if a rising market is forecast, being in cash if the market is forecast to fall. A more aggressive form of market timing is to be short in the market rather than in cash.

Notice - cash is a position.

Investors using an asset or sector rotation system often insist that they do not time the market.

On one occasion, I attended an investing presentation where the speaker disavowed timing the market only to then describe how their firm moved from sector to sector based on an evaluation of the market. Hmmm.

Buy and hold is not market timing.

Even if you are not interested in timing the market, it is worth understanding how to analyze the market.

Rationale for a market timing system

The usual rationale for timing is that if you missed the worst 20 days of the market you would be so much better off.  The usual counter argument for being fully invested at all times is that if you missed the best 20 days of the market, your returns would suffer.  Yes, it is ugly.

One thing to keep in mind is that the worst 20 days and the best 20 days often occur at about the same time.  The extreme market swings in October and November 2008 are a good illustration.  Record drops in the market followed by record upswings. 

The second most common rationale is that a stock market timing system may keep a novice investor from losing a big chunk of their nest egg.  Most of us do not deal with significant losses of our money. If you were able to observe the panic of the newly retired in 2000 and 2001, and again in 2008 you probably witnessed the emotional effect of having a nest egg take a big hit.

Duration and direction of timing periods

Market timing is often characterized as tides (primary waves), waves (secondary waves) and ripples in the market.  The point is that timers with a long time frame try to identify tides in the market.  Timers with a shorter time frame try to identify the waves and those with a very short time frame try to identify the ripples in the market.

Market direction is important. Going with the flow of the market according to IBD (Investors Business Daily),accounts for 65% to 75% of the success of a trade.  You do not want to be swimming against the tide if possible.

The rotation of the sectors (i.e., identifying the sectors with the most strength) accounts for most of the remaining success. Market timing views actual stock selection as the least important part of the process.

Methods of Timing the Market

The methods employed in market timing can generally be categorized as follows:

• Dow Theory
• Market Breadth
• Stock Market Cycles
• Investor Sentiment
• Economic Indicators and Financial Indicators
• Market Timing Systems

Note that the final category is a combination of components from other categories.

Dow Theory

The Dow Theory was derived from editorials by Charles Dow - editor of the Wall Street Journal until 1902.  A basic assumption is that everything that can be known about the market is reflected through the price.  Further, the market will trend up, trend down or move in a lateral fashion as a function of primary waves, secondary waves and market ripples.

Therefore, studying the price action and volume of the market as a whole can guide your investment decisions.  Any technical analysis system of timing the market would fall into this category.

Market Breadth

While the Dow Theory considers the market as a whole when timing the market, market breadth considers the individual components of the market.  In other words, examining the price/volume action of stocks in the market will provide insight into the market direction.

Stock Market Cycles

A market cycle differs from the Dow Theory in that the cycles are more consistent than waves and ripples in their length.  Stock market cycles are similar in the sense that price is a function of the summation of all cycles just as price would be a sum of the waves and ripples.  Both the Dow Theory and Stock Market Cycles allow for unexpected events.

Investor Sentiment

Market sentiment systems are contrarian in nature.  They rest on the idea that at extremes of sentiment, the crowd is usually wrong. Knowing when sentiment has reached an extreme can be a difficulty with any sentiment-based system.  How long the extreme will last is also an issue.

Economic Indicators and Financial Indicators

Economic and financial indicators are generally categorized and leading, lagging or co-incident. They are really most like warnings to check other, more precise indicators.

One problem with the leading indicators is that they are general. For example, a recession usually begins 12 to 18 months after the yield curve inverts.  A lagging indicator is equivalent to looking in the rear view mirror while driving - too late to do much planning.

Market Timing Systems

If you are going to time the market, it is unlikely you will rely on just one signal.  The common approach is to rely on confirmation of any one signal by at least one other signal.  It is generally good practice to select signals from different categories for confirmation.

Return from Timing the Market to Stock Screening 101 home