Some analysts claim that they are able to time the stock market and only invest during bull markets. The premise is simple: Buy stocks when the aggregate market is climbing and sell at the onset of a bear market.
In theory, you can maximize gains and virtually eliminate losses.
But is this possible? Do such strategies exist?
An Example of Market Timing
The conglomeration of publicly traded companies is often represented by a smaller cross-section of stocks called an index. For our example, we will use the well-known Standard and Poor’s 500 index, or S&P 500. This index is focused on large American companies and is typically used to gauge the stock market in general.
During the three year period from January 2008 to January 2011, the S&P 500 lost 12.11%. If you owned stock in multiple large American companies, it’s likely you would’ve experienced a similar amount of loss during this time. Now imagine you sold your shares before the January ’08 crash and bought at the beginning of the bull cycle in March 2009. In less than 2 years, you would’ve been up 88%.
If, on the other hand, you had the foresight to short sell the bear market, you would have a non-compounded gain of over 140% – which is a far better reward than losing 12.11% for buying and holding.
Why Timing the Market Is Difficult
However, market timing is difficult, if it’s even possible at all. There are compelling arguments against the idea of “buying the bull and selling the bear.”
1. The Efficient Market Theory
The efficient market hypothesis is a popular concept that states that all stocks are properly valued at all times based on all available information. A stock is neither undervalued nor overvalued, but it is exactly where it should be.
If this is true, market timing is impossible since prices will immediately reflect any changes upon new information becoming available. In other words, there is no time for you to react in advance of the market by buying or selling stock before it goes up or down.
2. Isolated Days of Huge Movement
A study called Black Swans and Market Timing: How Not to Generate Alpha examined the effect of outliers, or abnormal trading days, on a long-term portfolio. The study removed the 10 worst days of market activity between 1990 and 2006, and the portfolio value jumped 150.4% higher than a passive one that remained invested the entire time.
When they removed the 10 best days, the portfolio value dropped by more than 50%. But since these largely unpredictable “black swans” occur less than 0.1% of the time, the paper concluded that it’s better to buy and hold than try to guess when these isolated periods might occur.
3. Mutual Fund Performance
The paper titled Mutual Fund Performance cited a broad U.S. and UK study on mutual funds. One finding was that active fund managers were, on average, able to very slightly time the market. However, their net gains were almost entirely consumed in management and transaction fees and thereby had virtually no effect on overall fund performance. If trained professionals that actively manage mutual funds can only slightly time the market, it’s unlikely that casual investors will be able to do so at all. It’s also important to beware of common lies told by mutual fund managers.
4. Conflicting Indicators
Since there are a glut of fundamental and technical indicators available – many of which conflict – which do you follow? In other words, how do you react when the employment rate is dropping, but stocks rise to new highs on increased earnings? Should you buy when stocks are well below historical price-to-earnings ratios despite high volume selling? For every report and survey suggesting one direction, there is usually a contradicting indicator that suggests the opposite.
5. Looking to the Past
How do you prove the efficacy of a market timing model? You generally do so by back-testing it with historical data. But by constantly looking to the past to validate a system, you run the risk of curve-fitting data that appears to work well in hindsight, but may have little predictive power for the future.
Moreover, even if a trend has expressed itself multiple times historically, economic, political, industry, and company-specific factors can change, such that the trend is essentially no longer relevant.
Market Timing Strategies
While some say that timing the market is virtually impossible, there are others that claim such a feat is indeed achievable. What techniques do they use and what proof do they have that market timing is a practical and profitable endeavor?
1. Following the Trend
If the market moves in cycles, then it should be possible to use technical tools to quantify those trends and determine with a measure of accuracy bull and bear market stages. A moving average is one simple method to achieve just that.
The moving average is a line that plots the average price of a stock over a set period of time. A basic trading method is to buy when share prices rise above the long-term moving average and sell when the price falls below. In the paper, Technical Analysis with a Long Term Perspective: Trading Strategies and Market Timing Ability, some uncommon approaches were evaluated. One strategy was to analyze the trailing four years of market data to determine which moving average length proved the most effective for making investment decisions. Contrary to the usual calculation of moving averages using periods as short as 50 or 200 days, the moving averages in this paper were calculated over much longer periods of time.
So did this long-term moving average strategy achieve excess market gains? Well, while the S&P 500 returned 90% between 1994 and 2009, this dynamic use of a long-term moving average returned 572%. Undoubtedly, these results are impressive. But it’s prudent to remember that past returns are not a foolproof indicator of future performance.
2. The Revised FED Model
Ed Yardeni, who was the Chief Investment Strategist for Oak Associates as well as a professor and an economist at the Federal Reserve Bank, developed the FED model. This model compares bond rates to equity premiums. For example, if the 10-year Treasury note has a higher earnings yield than the stock market (as calculated based on the trailing 12 months), you should buy bonds. If, on the other hand, the earnings yield of the market is above that of bonds, you should buy equities.
However, this model has inherent problems since stocks carry more risk and are more volatile than government bonds. For example, future earnings forecasts may rise or fall in equity markets, which can positively or adversely affect your investment. What if the 12-month earnings predictions are dreadful as the economy is forecasted to go into a recession? The traditional Fed Model would not account for this future performance and therefore may inaccurately suggest to investors that stocks represent a better option than bonds.
It was out of a need to account for such volatility that the Revised FED Model was created. This model essentially adds projected earnings to the analysis. In other words, if stock market earnings are expected to rise over the next year, then the FED Model is dependable and investors can simply compare earnings yields between bonds and stocks. But if stock market earnings are predicted to decline, then this strategy is ineffective. By accounting for projected earnings, the Revised Fed Model creates a more reliable method of investing.
So how would this market timing system have fared over the past five years? According to fundamental back-testing, these two simple rules would have generated an 18.9% annualized return with a 17.4% max drawdown, and the 5-year total return would have been 137.26%. (Drawdown refers to the amount of portfolio loss from peak to trough.) In comparison, the market had an annualized 0.65% return and a 5-year gain of 3.3% with a 56% max drawdown.
While this strategy has exhibited impressive returns, it still depends on the qualitative analysis of many analysts with regards to projected future earnings. If unexpected economic circumstances arise that hurt the economy, even the Revised FED Model can lead investors into unprofitable decisions.
3. CAN SLIM
William J. O’Neil developed a high-growth trading system that uses the acronym CAN SLIM. This strategy dictates that you only invest in the market during bull stages, and utilizes an innovative technique to determine when those stages occur.
In contrast to models that follow earnings or trends, William O’Neil tracks the “big money” by following trading cues from institutions. He asserts that you can guess when institutions are selling since the market indices will show high volume without any price advance. He calls these “distribution days” or selling days. If you see four or five of these high volume sell-off days within one trading month, be prepared for a succeeding price drop. In other words, you should sell your equities and be in a cash position for the potential bear phase.
But how profitable is this market timing model? It is difficult to tell. While screening for high-growth stocks according to the CAN SLIM methodology is quite simple with software, the analysis of the market is quite interpretive and typically requires a visual approach. I am not familiar with a specific computerized and back-testable algorithm that is able to emulate this market timing technique. But as reported by the American Association of Individual Investors, the 5-year annualized return of the CAN SLIM stock picking method is 21.9%. That said, how much gain can be had from this isolated market timing technique is not readily available knowledge.
4. Short-Term Technical Analysis
Some investors are primarily concerned with identifying large market cycles that endure for years at a time. Yet other traders try to isolate very narrow windows to make quick trades based on mini-market pops and drops which may last only weeks. One system uses a complex set of rules based on price and volume indicators developed by Marc Chaikin. The 10-year total return from this system is 1,388.9% or 30.3% annualized. While this may seem like the world’s greatest investing system ever, I took a closer look at how this system might work for an average investor.
I re-ran the simulation and accounted for transaction fees of $20 per trade. I also factored in slippage of 0.50% because buying large positions over a short period of time will drive prices up and cause slippage. This resulted in a 5-year annualized return of 18.9% with a max drawdown of 38.4%, and 45% of the trades were winners. But perhaps most importantly, there was a massive turnover of stocks to the tune of 400% per year, which would result in hefty fees and require a significant time investment.
While back-testing such techniques reveals profitable results, it is not a slam-dunk for future outcomes. Like any system, it takes a disciplined investor to follow the system and not be swayed by their own emotions when the data is not in agreement. Even for proven market timing strategies, there will always be investor error to consider, since computer-based models don’t take this into account. Moreover, the economy and market are ever-changing and may introduce new variables or alter old assumptions which can further complicate these strategies or affect their results.
Certainly, there are strong opinions on the efficacy of timing methods, perhaps driven by their promise of great rewards. While some assert that timing the market is possible and highly profitable, others claim that market timing is either impossible or not worth the risk. Nonetheless, it remains to be seen which of these market timing strategies will stand the test of time, if any, and what new ones will be developed. Much research and testing still needs to be done to legitimize market timing theories among academics and investors alike.
Do you try to time the market with your investing strategies? How much success have you had?