I'm not a fan of the term "market timing" as I believe it implies some sort of prediction about the market with certainty. The future is unknowable, because it simply doesn't exist. But that's not to say that systems can't have predictive ability in that they result in a positive mathematical expectation (average profits that exceed average loss for a positive return). Nor am I a fan of quantitative indicators that are a derivative of price. That is, I believe any quantitative ratio or indicator that isn't based on the actual price trend can lead to surprising outlier moves because a fundamental valuation indicator can stray far from the price trend itself. For example, if you buy low P/E stocks or stocks you believe are below "intrinsic value", you may at times be proven wrong. That's usually going to happen when stocks become "overvalued" like many thought in the late 1990's, or it happens after a waterfall decline with losses of -50% or more like 2002 or 2008. Relative value measures often flash their warning lights long before a big bubble uptrend is over and they flash buy signals long before a major waterfall crash is finished. These contrarian strategies using "fundamental valuation" aren't just hard to do because they can be wrong for so long, they can also be costly when they stray so far from the actual price trend. I prefer to ride the price trend and it's the price trend itself that is both the judge and the jury; so quantitative price based methods are necessary to exploit directional trends and manage downside risk. But, even though what I say is based on my own experience, empirical evidence, and quantitative research, that isn't to say that the method can't work. I just think there are better ways.
Few investment strategies have a worse reputation than market timing. Investors are told that their
best strategy in stock investing is a simple “buy-and-hold” strategy: buy a diversified stock market index and
hold it. Yet most investment literature assumes that investors will hold a security if and only if its expected
return at the market price provides an adequate tradeoff with the risk exposure the security brings. In other
words, investors are assumed to make their own judgment on whether a security is worth holding. Saying
that investors should not “time the market” is equivalent to saying that consumers should not maximize
utility when making consumption decisions.
1
The standard reply to this criticism is that because the stock
market is fairly efficient, accurate market timing is very difficult. In fact, it is said to be so difficult that
investors are better off not trying.
Few investment strategies have a worse reputation than market timing. Investors are told that their
best strategy in stock investing is a simple “buy-and-hold” strategy: buy a diversified stock market index and
hold it. Yet most investment literature assumes that investors will hold a security if and only if its expected
return at the market price provides an adequate tradeoff with the risk exposure the security brings. In other
words, investors are assumed to make their own judgment on whether a security is worth holding. Saying
that investors should not “time the market” is equivalent to saying that consumers should not maximize
utility when making consumption decisions.
1
The standard reply to this criticism is that because the stock
market is fairly efficient, accurate market timing is very difficult. In fact, it is said to be so difficult that
investors are better off not trying.
With that said, Pu Shen, an economist at the Federal Reserve Bank of Kansas City, wrote an interesting paper titled "Market Timing Strategies That Worked" in 2002. He studied switching strategies based on a simple relative valuation that signaled when stocks may be overvalued or undervalued. He concludes:
We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances.
Our resarch suggests that it may be possible to use a simple rule of thumb to avoid some of the market downturns and improve upon the widely preached buy and hold strategy.
In that case, so much for the "You can't beat the market" mantra. He finds that 4 of the 5 strategies he studies outperformed the S&P 500 stock index with less risk, even after factoring in transaction costs. In the opening paragraphs, he says:
Few investment strategies have a worse reputation than market timing. Investors are told that their best strategy in stock investing is a simple “buy-and-hold” strategy: buy a diversified stock market index and hold it. Yet most investment literature assumes that investors will hold a security if and only if its expected return at the market price provides an adequate tradeoff with the risk exposure the security brings. In other words, investors are assumed to make their own judgment on whether a security is worth holding. Saying that investors should not “time the market” is equivalent to saying that consumers should not maximize utility when making consumption decisions.
The standard reply to this criticism is that because the stock market is fairly efficient, accurate market timing is very difficult. In fact, it is said to be so difficult that investors are better off not trying.
I guess that pretty much speaks for itself.
I will add that everyone has an agenda. The objective for someone switching or rotating capital between cash, stocks, bonds, commodities, and currencies is to avoid large losses when any of those markets are trending down and profit from their positive directional trends. In other words, it's a pursuit of profit > loss. The buy and hold investors he speaks of pursue market returns, which anyone can get in low cost passive index funds. We don't need any advice, tactical portfolio management, or active risk management, or even skill, to get market returns. If it's market returns they want: they buy and hold the index. If they feel the market returns have too large of losses and/or too little reward, then a tactical rotation may be necessary. In other words, if the market indices haven't provided the risk/reward profile a person needs, then they may need to extract from those indices the parts they want with a quantitative system of some kind that has a mathmatical basis behind it.
It's pretty clear that the person pursuing an active rotational strategy is "doing something" toward achieving his or her objectives. So, I can't argue too much against any strategy that's at least pursuing the same rational goals as me. By definition, a rational person is one who "does something" in pursuit of bettering circumstances. A non-rational person is one who doesn't. People often ask me why so much of the investment industry seems to promote passive strategies like "buy and hold". I don't necessarily think "most" of the industry does do that- I think it's mainly the retail broker/advisor and mutual fund companies who do. Again, it's probably a function of their agenda. You see, the mutual fund only gets paid if you keep your money in their fund, so their agenda is to keep you buying and holding. And they mostly remain fully invested no matter how much the market goes down. It would be irrational for them to tell you to sell their fund, ever. So, they come up with all kinds of spin in attempt to get you to hold their fund. Then, there are the retail broker financial advisors. Each of them probably have their own reasons for asset allocating, but not rotating even when the market is moving against them. We know that trade commissions is not longer a reason: we can now buy and sell Exchange Traded Funds (ETF) for free at many brokers. In reality, developing and operating robust tactical rotational strategies that have a positive mathematical expectation requires a lot of different skills and those skills are absolutely uncommon. Indeed, I know of fellow portfolio managers who've been trying for years with no success if we define it as good performance results over a full market cycle.
But, those who think it isn't possible, or who can't do it themselves, shouldn't interupt those who are...
