Market Timing Investing Strategy: Very Few Succeed

Since I pointed out one of my favorite strategies I thought it was only fair that I point out my two least favorite strategies. Market Timing is one of them. No investor has ever been able accurately time the market for long periods of time. However, I will provide a thorough review because there is always a small population of people that want to reap all the benefits of investing without taking any of the risks regardless of what reality and conventional wisdom have proven over and over again.

Market Timers use fundamental analysis, technical analysis and historical data to build predictive mathematical models. These market timing models are designed to predict what the market is going to do and time when it will react to changing conditions. They don't try to time the performance of an individual investment, they try to predict the broad market indexes such as the S&P 500 and then base individual investment decisions on the overall market direction.

A Market Timer's goal is to be in the right investments at the right time. For example, they never want to be in stocks when the market is bearish and they never want to be in cash or bonds when the market is bullish. When a Market Timer's model and analysis is giving bullish signals, they invest 100% of their money, and they usually put everything in broad indexes such as the S&P 500 or the Russell 2000. If they are receiving bearish signals, they will move their money into investments that don't correlate with the market such as cash, money markets and bonds.

Many Market timers try to enhance their returns by trading options. If their model is giving bullish signals they will trade an index or stock long, which is a fancy way of saying they will make a bet that the market will go up. When the model gives bearish signals they will sell short, which means they make a bet that the market is going to go down. Beware, options are risky, especially if you have very little experience trading derivatives. They can lose money much faster than a stock, especially if you bet wrong and the option contract is close to expiration.

Investment Selection Methods

Market Timers build models based on fundamental analysis, technical analysis and historical data that are designed to predict the market cycle. Every market goes through the same phases and a Market Timer attempts to predict when they will enter and exit each phase.

The four phases of a market cycle are accumulation, mark-up, distribution, and mark-down.

  • Accumulation occurs when first movers are beginning to buy up bargain stocks that appear undervalued. Investor sentiment moves from bearish to neutral during this phase.
  • Mark-Up occurs when a lot of investors decide to follow the early movers. This creates big gains as investors flood into the market. Investor sentiment goes from neutral to strongly bullish during this phase.
  • During distribution the market becomes very choppy. It will test the high several times before it eventually reverses direction and starts contracting. Many investors take their profit and start moving into less volatile assets near the end of the Distribution phase. There's a great deal of fear during this phase due to the unpredictable nature of the market, sentiment becomes bearish.
  • In the final Mark-Down phase investors flee the market in droves. This is a painful phase for those that stubbornly hold onto aggressive positions hoping for a turnaround. They take big losses because most of the volume is selling and the market is in full-blown correction mode. Eventually, many investors give up and bail out of their positions and stock valuations approach historic lows. Sentiment is very negative and bearish during Mark-Down. This phase ends when the next cycle's first movers recognize that the market is approaching a bottom and that there are bargains available.

A successful Market Timing model needs to perform two functions consistently and accurately. First, it needs to accurately predict the top and bottom of each market cycle. Second, it must provide bullish and bearish buy/sell timing signals that the Market Timer can act on. In other words, your model must be omniscient. If you build one, please forward a copy, that would really save me a lot of work.

Risks

The market is complex, there are an enormous number of interacting factors that affect each cycle. This naturally results in a lot of false indicators. Volatility and unexpected conditions that aren't accounted for in a model's data can trick it into thinking the market has reached the end of a cycle. In addition, each market cycle tends to be slightly different than the last, there are always new factors to consider. This makes a model that predicts future behavior based only on historical data practically useless.

The duration of market cycles is constantly changing and different markets will be on different phases of their cycle. The S&P 500 for example doesn't coincide and isn't a good predictor of the Small Cap market cycle. In fact, past S&P 500 market cycle durations aren't even a good predictor of future S&P 500 market cycles.

The greatest danger for Market Timers is options trading. Options are even risky investment vehicles for experienced traders. Market Timers tend to want to short bear markets and go long in bull markets because they believe they know what is going to happen. Depending on how badly they leverage themselves, this can have severe consequences to your portfolio when you bet the wrong direction.

Benefits

This can be a great capital preservation strategy if implemented conservatively and if you are able to trade in a tax deferred account. A cautious Market Timer spends a lot of time in low risk Bonds, Money Markets, and Blue Chips waiting for the perfect moment to enter the market. Conservative Market Timers also avoid trading Options. They may miss out on a lot of rallies with this approach but they never have to worry about losing big chunks of their nest egg.

Another positive of this strategy is that, when Market Timers are fully invested in the stock market they tend to be in broad based Indexes. Even if we don't agree with trying to time the market (we instead suggest a fully diversified Buy-and-Hold approach), investing money in broad market indexes is always a good thing. Read our Index Investing Review or our Complete Index Investor's Guide if you'd like to learn more about our favorite strategy, Index Investing.

Long-Term Outlook

This strategy doesn't appeal to many investors, but it will never go away completely. There will always be a small percentage of the population that want to invest in bull markets and sit on the sidelines for bear markets and believe they can predict future market directions well enough to do so.

There are more investors that accidentally attempt to time the market than there are investors that actively follow this strategy. The accidental market timers are those that panic sell when their portfolio loses more money than they are comfortable losing or that flood into aggressive investments out of greed during the Mark-Up phase. Accidental Market Timers constantly buy high and sell low so if you know one, do a good deed and guide them to another strategy.

Investor Profile

The types of investors attracted to this strategy are on opposite ends of the risk tolerance spectrum. This approach appeals to extremely conservative investors that would like to spend most of their time in low-risk low-return investments but occasionally venture into more aggressive assets when the market looks agreeable. The strategy also appeals to Day Traders, a high-risk breed of investor. They will frequently try to time the market with options because their statistical and technical analysis is designed to identify and capitalize on trends and short-term market behavior.

Since I don't recommend this stock market investing strategy I won't point out professional investors that practice market timing, and they probably wouldn't want to be associated with a negative review anyway. However, I will tell you that a few hedge fund managers have been able to make this strategy work, but I believe that is because they incorporate much more into their models and their strategy than just Market Timing. Hedge Fund Managers also spend 80 to 100 hours a week studying their models and the market, they are always the first movers. If a new trend develops you can count on a hedge fund manager to be the first to take advantage and therefore reap much more of the benefits. For this reason, I associate them more with Momentum Investing even if they call themselves Market Timers.

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