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Economic cycle based market timing

  1. Introduction
  2. Popular 401K investors delusions
  3. Fashionable mutual funds mix
  4. Follow the leader
  5. Naive siegelism
  6. "Financial alchemist" strategy
  7. Stable value only or "Depression might start tomorrow" strategy.
  8. Bonds-based strategy
  9. "Gold always shines bright"  and "Commodities rulez" strategies
  10. Lifecycle strategies
  11. Economic cycle based market timing
  12. Combination of lifetime strategies with market timing.
  13. Conclusions
  14. Webliography
  15. Old News

The phrase "market timing" has been misused and misunderstood. Any financial instrument be it stock or bond or commodity is purchased with the expectation it will be worth more over "time." And any trade including rebalancing is essentially a market timing (for example, usually a bad market timing in case of "blind" annual rebalancing). Anyway both stocks and bonds are sold when the expectation is that their value will either stagnate or decrease. Any analysis intended to create a profitable return on investing, is a form of market timing.  And it can a 'slow motion' not daytrading type of activity as described in this article published in 2002 which in many ways reminds us of 2008

Prescient Professor Favors Market Timing

Prescient Professor Favors Market Timing

     By Craig Karmin and Michael R. Sesit

Before the bubble burst, Yale economics professor Robert Shiller warned investors early on that the bull market was doomed to end in tears in his prescient book, "Irrational Exuberance," published in March 2000.

Now he has another gloomy prediction: Though stocks are at a five-year low, they remain historically expensive and could end the decade where they began.

But investors still can make a profit, he suggests, by trying something derided by many others as irrational: market timing, or hopping in and out of the market, selling during the upswings and buying on down- swings.

"Market timing has gotten an excessively bad reputation," he says. "Conventional wisdom holds that it's a fool's errand. It's certainly not an exact science, but I think people will come back to it."

The Dow and S&P 500While Mr. Shiller doesn't say specifically when is the right time to jump back into stocks--and won't predict how much further stocks could fall -- he suggests largely avoiding them until valuations, based in part on improved earnings, revert to their historical averages. He also advises watching for anecdotal signs that investor confidence has bottomed.

As it turns out, Mr. Shiller says he has been something of a market timer, albeit on a very long-term horizon. In 1982, at the start of the bull market, all his savings were in stocks. Even 14 years later, when he testified before the Federal Reserve board of directors that he felt the stock market was becoming dangerously high, he was still largely invested in stocks.

But shortly after Fed Chairman Alan Greenspan pronounced in December 1996 that the market had fallen victim to "irrational exuberance," Mr. Shiller began to sell down his positions until by 1999, he had only about 2% to 3% of his savings in stocks.

With his profits, he sought the safety of bonds and land: real-estate investment trusts, a real-estate investment fund, Treasury bonds and other fixed-income securities.

Although stocks have plummeted in the past two years, the time isn't right yet to jump back into the stock market, he thinks. First, he wants to see the questions about the trustworthiness of corporate earnings resolved and for valuations to revert closer to historic norms. By Mr. Shiller's calculations, the Standard & Poor's 500-stock Index is trading at a ratio of 21 times its 10-year trailing earnings, compared with an average of 15 between 1871 and 1990. Even if the market falls to the historical average, he says, the S&P 500 was below that level half the time.

But that valuation milestone alone would not be enough. "The market isn't just driven by profit expectations," he says. "It's also dependent on a public willingness to hold stocks."

Mr. Shiller thinks there are still too many investors who contend that stocks always go up in the long run. As the market ebbs and flows over the coming decade, he suggests, one by one people will abandon this belief and sell down their positions, keeping a lid on stock prices for years. The seeds of the next extended bull market, therefore, will be planted by disbanded investment clubs and a widespread feeling that it is passé to discuss where the Dow Jones Industrial Average closed.

"You want to go to a barbecue and hear someone say, ‘People used to think stocks always go up in the long run. I don't believe that anymore,’" explains Mr. Shiller, who says that would be a buy sign.

How long might an ensuing rally last before market-timing investors should again sell stocks? Again, he's reluctant to give a specific time period or price target, but notes that he is skeptical that any rally will last too long, since many weary individuals will be tempted to sell on the way up as they reach their break-even points.

In his book, published shortly before the S&P 500 hit an all-time high, Mr. Shiller argued that a speculative bubble was being fueled by investors who took it on faith that stocks represented the superior investment vehicle to be held under all conditions, even when the market was overpriced. This collective belief, he maintains, became a "self-fulfilling prophecy based on similar hunches held by a vast cross-section of large and small investors and rein- forced by news media."

It's the exact reverse of this that will keep stocks overall from surging, Prof. Shiller says. Public opinion has turned so dramatically against the once-burgeoning equity culture, he explains, that it is reminiscent of the dour mood of the 1930s bear market. "After the crash in 1929, it took a whole new generation to start buying stocks," he notes. Today, "the market is still overpriced and looks risky. It might be 10 years before people embrace stocks again."

The most egregious offenders of the 1990s, especially the technology stocks, could be out of favor for much longer than that, he reasons, since they are the ones that caused the most pain and suffering. Some new sector will eventually capture the public imagination, he thinks.

But until then, bonds and real estate will attract the crowds.

Another pessimist, across the Atlantic, agrees with Mr. Shiller's analysis. Mark Howdle, until recently a European market strategist for Citigroup Inc.'s Schroder Salomon Smith Barney unit and now in a graduate studies program at Cambridge University, suggests in that stocks will continue to face a strong headwind in both the U.S. and Europe.

During the extended bull market period of 1982 to 2000, when the Dow Jones Industrial Average soared eight-fold, investors found scant reward for looking beyond the stock market.

But in his report, "How Changing Fundamentals Reshaped the Investment Landscape," Mr. Howdle maintains that was a period uniquely favorable to share appreciation: Stricter monetary policy and lower oil prices kept inflation in check; corporate profitability rose in most every major market in the U.S. and Europe; and greater attention to corporate governance and the end of the Cold War reduced the risks associated with share ownership.

"It was a pointless task to try to pick short periods when you had to be out of the market, because you had to scramble back into it," Mr. Howdle says.

But the market reversal has changed that. "Now market timing--and asset allocation--can make or break the performance for individuals or investing institutions," he argues. "It's a trader's market; the supreme skill is knowing when to be out and when to be back in." But he cautions that this is a strategy that could prove particularly challenging for individual investors who don't have access to the same data bases and number crunchers as professional fund managers.

There are several prepackages "pseudomarket timing funds" like Vanguard Asset Allocation (VAARX):

The investment seeks to maximize long-term total return. The fund allocates assets among common stocks, bonds, and money-market instruments. It varies the asset mix according to the relative attractiveness of the asset classes; there is no limitation as to the amount of assets in each class. The advisor evaluates common stocks using a dividend-discount model, a mathematical model that evaluates stocks according to the projected worth of their dividends. The bond portion consists primarily of long-term U.S. Treasuries or securities issued by other government agencies.

It is down approximately 20% as of October 2008, so its "sector rotation" is probably modest.  Five year return is 5.16%.

Do it yourself market timers usually use index stock funds like S&P500 or Total market and available in 401K bond fund (or, if no suitable bond funds are avilable, stable value fund). They sell the index fund when they expect it will decrease in value. There are obvious advantages of getting this maneuver right :-).

Imagine for a moment an investor, following such strategy, who planned to retire in 2003. He would sell stock funds before they crash in 2000 and can enjoy large portion of the profits from the bubble.  But if he did the same in 1998 he is definitely less fortunate and such premature sell-offs are the major danger of market timing. Signal might be right but usually it flashes one or two years early.

Another consideration is that buy and hold with huge stock portfolio is very dangerous close to retirement when one downward move can bite a huge chunk of your egg nest.  If, for example, an investor who was the adept of Siegelism (which was pretty much the most popular investment religion of the time) decided to retire in 2002 and sold its holdings during the minimum of S&P500 for this period he might have lost substantial part of his/her investment (50% off the peak). And now in 2008 it got into second, probably more powerful wave of decline and with less then 10 years before retirement is outright scary.

One type of market timing is based on the observation that movement of most stocks are highly inertial and the current direction mostly holds. That means that it pays to follow the direction of the broad market represented by index. The simplest market timing strategy belonging to this category is called 200 days Moving Average strategy. While very simple it requires iron discipline to implement and for this reason I would not recommend it to 401K investors. The problem is that to buy or sell all your holdings due to the questionable signal is both risky (many such signals are false positives) and difficult psychologically. This strategy was briefly mentioned by Siegel in his "Stocks for a long run" book, who actually argued against it.   Although the book as a whole smells with primitive and naive empiricism, this chapter of the book is actually a rather interesting read. Siegel proposed 1% over or under 200 days average as "stop-loss" and "all-in" signals.

But gradual reduction of  your stock exposure is much easier and less painful move, especially after a good bull run. Even 50% reduction of stock holdings would have kept most 401k investors from losing their shirts in the 2000-2002 bear market. When things improve (the stocks cross 200 moving average line from below) allocation can be moved back to where it belong according to, say, age-based formula. So it might make sense to use not 0-100% -- 100:0 stocks bonds split for bear market and bull market, but 20:80 -- 80:20.

Obviously you can create more complex signal then just crossing by stock price of the 200 day moving average and add additional parameters like P/E ratio, Insider trading metric, as well as your age.  That brings us to the next strategy that can be called Combined lifetime/ market timing strategy.



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