Market Timing – Fool’s Gold

INVESTING SCENTS

There are those who believe you cannot possibly time the market in terms of entry and exit. Fair enough.

The random walk theory lies in the fact that you cannot beat the market over the long term. But we also have the proliferation of hedge funds where managers get a lucrative 20% of profits kicker annually on gains. If the random walk theory is correct, then the “hedgies” would be a terrible business to be in.

The out performance relative to the benchmark is called the alpha. Hence the name of the popular website Seeking Alpha.

Out performance can be gained via market timing strategy and/or superior stock selection strategy, to simplify matters.

For this article, I am only looking at market timing.

If we could really predict the market's moves, market timing would be great. The problem is that there is evidence to show that market timers do not do well.

An annual study by DALBAR, a research firm, showed that the average investor in equity funds has averaged only 4.3% per year in returns over the most recent 20-year period in which the S&P500 averaged 11.8% per year – and DALBAR finds that most of this under-performance of the basic market index is due to attempts to time the market.

There are a host of other studies that show that market timing leads to returns that substantially lag the market.

Even if there were a few funds out of the thousands that have proven to market time successfully and outperform consistently over a 5 or ten-year period, would it be smart to give them your money?

Essentially, you have to bet on these funds' ability to maintain their track record or on the long-term evidence pointing to the low success rate of market timing.

There is a large body of research, which concludes that actively-managed funds that beat the market in some period are not likely to continue to out-perform over any extended period.

In 1975, William Sharpe published a seminal article on this topic: “Likely Gains from Market Timing”. In this article Sharpe demonstrated statistically that in order to benefit from a market timing strategy you had to guess right 74% of the time. Hence it is possible, but very arduous indeed.

Alpha is a definition only; it may or may not exist. For people to get alpha, they need to be better at market timing and price timing.

Warren Buffett obviously does not believe in market timing or price timing. He sees them as businesses, and for the right price he will buy the business regardless of sentiment.

He may even suffer short-term weakness or short-term losses holding these businesses, but he does not market time or price time his purchases. To him, if the price is cheap relative to future value, then it's good enough.

If market timing and price timing works for only 5% (1 person in 20 is about right) of participants (or even just 1%), all studies would reveal that market timing and price timing does not work as the results are not substantiated – hence the random walk theory.

Suffice to say that even if the 5% or 1% do make it work (which is what I strongly believe), it's just that much harder.

When things are that much harder, many will opt for easier routes such as buy at good price and hold, or buy the business and forget the volatility.

I am not saying I can do this well. I am not saying anyone can do this well. I am suggesting that one can do market timing and price timing well provided they get two things right – the big picture and the catalysts.

People like Buffett and Lynch are big picture guys, but you still need to get the catalysts right for market timing to work properly. For example, Buffett has been short on USD since 2000 but he only made money over the last two years and lost some in the first 3 years. As for Soros, he is trying to be both. When he shorted the British pound and made billions, he got both right.

But even Soros cannot get both right all the time.

Getting the big picture right is the easy part. Determining the catalyst(s) for a dramatic change or trend swing is a lot harder.

Truth is, there is no known classes on catalysts like what is significant, what is not, the cumulative effect of several catalysts, catalysts for differing economic environment, how sentiment relates to catalysts and so forth.

If you see a bubble forming in an asset, say property, you can fairly judge the probable steps ahead for the market in coming to terms with the bubble: you project that prices will rise, there will be over-exuberance, followed by resistance to bearish calls, rising rates to counter inflation, prices stubbornly refusing to come down, start of some foreclosures, some concerns among banks, some leveraged property companies failing, rising foreclosures, a crisis being discussed by the media, and so on...

These are the natural chain of events, which make up catalysts in bringing to fruition changes to trends.

I do think that if someone learns to follow cycles and chain of events closely, they will be able to better time the market.

Someone who calls the Shanghai index overvalued at 4,500 on the way up would be a good read but a poor strategist. The index hit 6,500 before moving down to 4,000 six months later.

The pro is correct but if he made any money, he probably lost on the upside and if he kept short all the way from 4,500, he would have lost even more on a net basis.

One should have stayed invested as bull runs tend to overshoot, but stay alert to trade out on warning signs.

The listing of Petrochina on Shanghai was a “high” – how to recognise that as a critical catalyst? Experience, predicting capital flows and most importantly, predicting or anticipating the behaviour of investors.

Let me give you some recent examples:

·Subprime mess – Big picture calls were loud by mid-2007 but markets were still resilient. There were plenty of catalysts, but deciphering which one will break the camel's back is the hard part.

Sometimes, few cumulative catalysts are needed before the water overflows. I regard the second plunge of Countrywide to be a major catalyst, which prompted Bank of America to average down dramatically.

The other major catalyst was the Citigroup's write down, not of the CDOs holdings but because of the significant provisions made for future “problems with consumer debt”.

Thanks to CNBC and Bloomberg news, there is an overload of information. To be able to stand back and pick the real catalysts is nirvana, for want of a better word.

The key is getting the big picture right first. Then assess the catalysts accurately, but it can be an arduous task. If we still cannot market time or price time, then at least we know why we are not good at it.

To do well in market timing is like climbing the Everest. There are those who will make it to the top (very few, that is). Most will die trying halfway. Some will give up after a few inclines. Others will opt for hills instead.