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 identifying the state of the market with respect to investing. Is it favorable (forecast to rise) or adverse (forecast to fall)?

In some respects, it is like dressing appropriately based on weather conditions. We want to invest appropriately for market conditions.

The most common form of market timing alternates between being long when the market is favorable and being in cash when market conditions are adverse. A more aggressive form of market timing is to be short in the market when conditions are adverse.

Note: cash is a position.

Everyone times the market. Some people buy when they have money, and sell when they need money, while others use methods that are more sophisticated.

Marian McClellan

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.

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 an investor from losing a big chunk of their nest egg. Most of us do not deal well 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.

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.

IBD also feels the rotation of the sectors (i.e., identifying the sectors with the most strength) accounts for most of the remaining success.

Many market timers view actual stock selection as the least important part of the process. In other words, everyone looks like a genius in a strong bull market.

Methods of Timing the Market

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

  • Technical Analysis (Dow Theory)
  • Market Breadth
  • Stock Market Cycles
  • Investor Sentiment
  • Economic Indicators and Financial Indicators

These methods are described in more detail in Market Analysis.

Market Timing Systems

In her book about investing guru Warren Buffet, Janet Lowe quotes 2 of Buffet's investing rules:

  1. Rule 1: Never lose money
  2. Rule 2: Never forget Rule 1

This is the intent of the following market timing systems - avoid being exposed to the market when conditions are adverse. These are long term systems that try to identify market tides.

Keep in mind that no system deals with unexpected events. Just as ocean tides are overwhelmed by a tsunami, the market can be overwhelmed by events. There is no guarantee you will avoid a disaster.

Technical Analysis

Technical analysis of price and volume is the common form of Dow Theory and probably forms the core of most market timing systems. If everything that can be known about the market is reflected through analysis of price and volume, then timing the market using market prices and volume can guide your investment decisions.

This long term market timing system is based on an analysis of the monthly price action of the S&P 500 beginning in November 1957.

If you prefer to use a long term system tied to daily or weekly price action, the traditional "golden cross" system may be for you. The detailed analysis is not included but a description of how you can study it for yourself is. It is easy enough to use one of the free TA screeners (e.g., bigcharts or stockcharts) to determine the condition of the market at end of each day.

Seasonal Market Cycle

When it comes to timing the market, the "best six months" system is a clear winner for ease of use. It is based on stock market cycles and ties in nicely with the Wall Street adage "sell in May and go away".

Fundamental Analysis

If you have read Unexpected Returns by Ed Easterling, you are aware of the effect Market PE and interest rates have on market conditions.

Portfolio123 has an interesting approach to timing the market using the EPS of the S&P 500 combined with a Fed risk model which has been very effective since March 2001.

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Updated Jan 2013