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Stock Market Timing Strategies Best Used as Defensive Signals
market-timing-strategies.jpgMarket timing is a misunderstood concept and there is limited agreement among trading professionals and market commentators whether market timing works over the long-run.  Mutual fund companies and other proponents of the "buy and hold" investing style, which command the dominate voice in investing communities across the internet, will convince you that market timing does not work.  Mutual funds do not want short-term trading activities to occur in their funds because it costs them more to manage, and they will generate less fees if you sell their funds and switch into other funds or asset classes.   While the market timing versus "buy and hold" debate has been going on for years, we think during this time the greatest benefit of market timing has been overlooked.

Market Timing Helps You Avoid Catastrophic Portfolio Losses

Now that many investors have experienced the catastrophic and damaging effects of a bear market on their own investment portfolio, people are beginning to see that remaining invested in a bear market can actually increase the volatility and risk of their own investments.  In addition, the psychological pain associated with watching a lifetime of hard-earned investments substantially decrease in value over a sustained period of months can take a damaging toll on confidence levels and one's own general outlook on the financial future.

Practitioners using market timing signals saw the bear market coming and were active before significant declines took hold in the general market.   Market timers that practiced some type of market timing system or strategy were able to see these early warning signs and were able to switch into cash or other asset classes.   As the bear market took hold, market timing signals also began to highlight a new emerging trend in bonds and treasuries.    Market timers with higher risk tolerance levels acted on these signals and took short positions on the market to further capitalize on the emerging bear market trends.  The bottom line is that market timing signaled when to get out of the market, and acted as a defensive portfolio strategy mechanism to reduce risk.

Turning Market Timing on its Head

Many advocates of "buy and hold" investing will argue that the markets long-term bias or direction is an upward trend, so its just a matter of holding on... eventually the market will return to its long-term upward trend and your portfolio capital will eventually recover.  What's funny is that most market timing professionals agree with this statement, they just think there are better places to invest capital while the market is experiencing a major downtrend.  Why hold an investment for 15 months and watch it is decline in value by 50% when you could sell and stay in cash, or invest in bonds and make a positive return?  Advocates of market timing understand that the real power of a market timing system is knowing when to get out of a declining market, and not so much about picking winning investments.  Market timing signals are another tool in your investment toolbox to help you make better informed decisions in the marketplace.

Market TIming Can Help With Asset Allocation Decisions

A landmark study by Roger G. Ibbotson and Paul D. Kaplan titled "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?" was published in The Financial Analysts Journal in January/February of 2000.  Ibbotson and Kaplan used the 5 asset classes of large-cap US stock, small-cap US stock, non-US stock, US bonds, and cash in their study to examine the 10 year return of 94 US balanced mutual funds versus the corresponding indexed returns.  What their analysis revealed was that asset allocation explains about 90% of the variability of a fund’s returns over time, and it also explains 40% of the variation of returns across all funds.  They key point of this article is that the selection and timing of the asset classes included within a portfolio has a much greater influence on results than actual selection of securities.  To illustrate the point, imaging we are at the peak of a bull market, and about to experience a future 50% drop in valuation over the next 12 months.  At that point in time, if we allocate 100% into equities we will experience a 50% drop in valuation over the next 12 months, however if we had allocated 100% into Treasuries or Bonds we would have experienced a positive return.  The timing of when you make asset allocation decisions is also critical to your long run returns.  The use of market timing signals as an input to your asset allocation rebalancing decisions can have a great influence on your overall returns over time.

Market Timing and Asset Allocation Studies Show that it Can Work

There are several published studies in financial planning journals that suggest market timing and timing of your asset allocation can have a significant impact on long-term portfolio performance if practiced diligently and regularly.  Here are links to some of these market timing and asset allocation articles, and we encourage you to read them if you are considering your own market timing strategy:

"The Truth About Timing" by Jacqueline Doherty, published in Barrons in 2001 studied market timing as a capital preservation strategy and studied what the effect would be if an investor could avoid the 5 worst days of each calendar year over a 25 year period.  Her conclusion was that if you could time the market in this fashion, your results would be 85 times greater than a buy and hold investor over the 25 year period.  Although the practicality of achieving this result in the real world in difficult, it highlights the fact that market timing can assist with preserving your capital in downturns, allows more capital to be invested in upturns, and has a dramatic compounding effect over time.

"A Quantitative Approach to Tactical Asset Allocation", Journal of Wealth Management, Feb 2009  = concluded that if an investor used a monthly system of market timing with a simple timing indicator that the would have improved their risk-adjusted returns and avoided several devastating bear markets.  The conclusion noted that practicing a monthly market timing system would gave generated equity like returns, with the volatility and risk of bond volatility.

"Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?" by Roger G. Ibbotson and Paul D. Kaplan was published in The Financial Analysts Journal in January/February of 2000 and concluded asset allocation accounts for over 90% of the variability of a portfolios return, and 40% of return variations across different fund asset allocation levels.

Benefits of Stock Market Timing Systems

Market timing preserves capital.  Practicing a simple market timing system can help preserve your portfolio capital during major market downturns.  Acting on these timing signals and selling into cash or treasuries can preserve a lifetime of gains while you ride out the bear market storm with your holdings in less volatile investments
 
Stock market timing can reduce portfolio risk.  Having the ability to avoid or limit exposure to bear markets that plummet 50 - 60% in value over the course of a year can substantially reduce the level of volatility and market risk inside your portfolio over the long term. 

Market timing signals can reduce financial worries.  Nothing is more painful that the watching a lifetime of savings disappear.  Market timing signals can help avoid the psychological pain associated with major erosions of portfolio values

Stock market timing increases consistency of returns over time.  Diligent practice of market timing and asset allocation can help increase the consistency of portfolio returns over time by minimizing the impact of long-term declining markets. 

Market timing acts as a secondary confirmation.  With most successful market timing systems based on quantitative data-driven models, they can provide a neutral secondary confirmation source on market trends that are free from human psychological and emotional bias. 

Market timing can be practiced with a wide range of investments.  Popular investment vehicles for market timing include ETFs, mutual funds, index funds, forex, commodities, futures, and stocks.

Market timing allows you to capitalize in bull and bear market trends.  With the rise in popularity of many inverse ETF funds you can easily short entire sectors or markets by purchasing an inverse ETF

Market Timing Is Best Used For Long Term Trends

The best timeframe to utilize market timing signals is for intermediate and long-term time frames.  Finding the right balance between effectiveness, usability of a system, and transaction costs makes stock market timing better suited for long term viewpoints.  Catching major bull markets in key sectors, avoiding major bear markets, and keeping transaction costs low is the name of the game for successful long-term market timing systems.  The average investor will have a very difficult time succeeding at market timing if their trading timeframe is very short.  Transaction costs, the time involved in tracking trades, and taxes will erode your long term gains over time.  Taxes are a major issue to consider carefully, and we recommend that most market timing activities should be reserved for tax-deferred or tax sheltered portfolios.

Market Timing is Ideal for 401Ks, Traditional IRAs and other Tax Sheltered Portfolios

The ability to shift into different asset classes without tax consequences is important if practicing a market timing system over a long period of time.  Transaction costs and taxes could easily erode the additional gains made with a market timing system, and that is why we do not recommend you use market timing unless it is in tax sheltered accounts, or only practiced infrequently in regular account to catch or avoid major market moves or corrections.  Luckily, trading transaction costs today are very competitive, and most 401k plans and traditional IRA plans have competitive cost structures and allow infrequent levels of fund switching for free. 

Market Timing with 401K and Other Employer Sponsored Plans.

Most 401k plans available today offer a varied range of investment options, with usually 7 or more asset categories as selections.  This gives you a great opportunity to allocate your 401k holdings into the top performing segments of your selection choice, and over time keep shifting your selection into the top performing categories.  Most 401k plans offer variations of the following asset classes:

Short term treasuries -  Great for capital preservation during turbulent markets, and easily outperforms in bear markets.  The trick is to know when to get into these funds before a major market meltdown, and when to get back into equities so you don't miss the next market boom.

Bond funds -  most plans have at least 2 types of bond funds.  Knowing when to allocate more or less to this fund during times of interest rate changes and equity market swings is the key to timing it well.

US Large Caps - US Large Capitalization Equities.  Great fund for bull markets to participate in long term gains, and also a solid choice for range-bound trading markets supported by these dividend producing leaders of our US market.

US Small and Midcap Equities - these fund offers a little more volatility along with greater upside potential by investing in smaller companies that may have a stronger growth curve ahead of them.  Time it right and the returns are large, but time it wrong and it will fall harder than the Large Cap Equities.

US Large Cap Growth -  great fund for bull markets to participate in long term gains as these funds capitalize on strong market momentum players, but can also fall harder.

US Large Cap Value - good fund for defensive positioning, and also a solid choice for range-bound trading markets supported by these dividend producing leaders of our US market.

International Fund - International EAFA Index.  International exposure to some of the largest global equities in the world.  More risk in this fund, but potentially more reward.  Important to watch your exposure here over time and be ready to switch out to preserve gains over time.

Market Timing with Your Thrift Savings Plan Account

If you are lucky enough to participate in the Federal Thrift Savings Plan you still have the ability to practice market timing with the plans offered.  With only 5 key funds your market timing strategy will be long term in nature, and will likely require fewer trades to still capture (or avoid) major market movements. 

G Fund - Government treasuries fund.  Great for capital preservation during turbulent markets, and easily outperforms in bear markets.  The trick is to know when to get into the G Fund before a major market meltdown, and when to get back into equities so you don't miss the next market boom.

F Fund - Aggregate Bond fund.  Solid bond exposure for your portfolio allocation.  Knowing when to allocate more or less to this fund during times of interest rate changes and equity market swings is the key to timing it well.

C Fund
- US Large Capitalization Equities.  Great fund for bull markets to participate in long term gains, and also a solid choice for range-bound trading markets supported by these dividend producing leaders of our US market.

S Fund - Small and Midcap Equities.  This fund offers a little more volatility along with greater upside potential by investing in smaller companies that may have a stronger growth curve ahead of them.  Time it right and the returns are large, but time it wrong and it will fall harder than the C Fund.

I Fund - International EAFA Index.  International exposure to some of the largest global equities in the world.  More risk in this fund, but potentially more reward.  Important to watch your exposure here over time and be ready to switch out to preserve gains over time.

Market Timing with Self Directed Roth IRA and Traditional IRA plans

With a much wider selection of investment options your greatest risk here is probably over-trading when following a market timing system, or straying too far into narrow investments and losing sight of diversification.  We recommend the use of Exchange Traded Funds (ETFs) if they are available due to their low cost structure and ability to trade like a stock without restrictions.  Index and sector funds are also a good tool to use with market timing systems and are widely available from most fund companies.  Pay close attention to expense ratios and opt for established index funds with the lowest management fees, and ones that have no upfront or deferred fees.

Market Timing Summary and How to Develop Your Own Signals

So what should we conclude about market timing strategies and asset allocation timing strategies?  Let's be clear, market timing is no silver bullet that can guarantee any success in the marketplace, just like any other approach to the markets.  But what is becoming clear is that market timing can help avoid significant and abnormal downside aberrations in market activity, and this over time is what will get you ahead.  Imagine the value of a portfolio today that simply bought the market index, but was able to avoid the last 3 bear market downturns?  This is where we see the greatest value in applying market timing signals to your own portfolio decisions.  The benefits of market timing can take many years, but when coupled with smart asset allocation decisions and low cost investments are a winning strategy to get ahead.  For more information how you can practice market timing read our7 free but seldom-practiced stock market investing strategies.

 

 
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