Market Timing 1 comments

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One of the most controversial topics in investing is the practice of market timing. Apparently the great investors don't, people like Warren Buffett and Peter Lynch: they focus on stock-picking and place an implicit faith in the ability of the markets to bounce back if it should experience a downturn. On the other hand, there are many who believe it is possible to spot the gathering clouds and bail out before the storm; these are often the more sophisticated technicalists who try to read the tea leaves from their charts and economic figures.

There is no doubt about the potential riches that could be obtained or losses avoided if market timing could be practised effectively. I have always believed that the market factor has the greatest influence on the performance of a stock, compared with sector and specific company performance (I usually think about it as 40:30:30 weighting).

To be sure, to a certain extent, the tea leaves could be read. There are three major factors that drive the stock market: fundamentals (valuations such as PE, dividend yield; operating performance figures such as margins), liquidity (money supply and bank credit, broker margins) and sentiment. It is obvious that when there is no more "spare capacity" in all three factors (for example, fundamental valuation have reached extreme levels, M1 money supply is at upper end of the range, sentiment has peaked to euphoric levels), there is nowhere for the market to go but down, in the same way as when a company has maximised profit when it maximises its capacity utilisation to 100% ie. no more room to grow. When only one of these factors appears to have reached a high value, the market may not have peaked. This is what happened in the dot-com boom when valuations reached 100X PE but because sentiment continued to surge and liquidity was floating around (cash-heavy unit trusts ready to buy, venture capitalists hunting for any dot-com startup to fund), the market continued to defy rational expectations of seasoned investors like Buffett.

The big question of course is, whether one can do this with impeccable flair. Judging whether there is "excess capacity" in the system to fuel a continued upward rise requires strong qualitative (on sentiment) and quantitative (on valuations, money supply) judgment. Similar to the ship captain who has to decide whether to cast off all heavy valuables (to make the ship more maneuvrable) because he thinks there might be a huge storm ahead, the decision to do market-timing is a function of one's willingness to sacrifice potential gains (in a bull market) or sustain further losses (in a bear market), of committment to stick to the course, and of confidence in one's judgment (the ship captain had better be right else his passengers would have something to say!)

Consider the two schools of thought in macroeconomic management: activist and non-activist. Activists believe they can intervene at appropriate periods to cool down or pump-prime the economy, while non-activists believe it is quite impossible to time these interventionist policies well even with a set of leading indicators. The usual practice now is limited intervention given that both schools have their points. Given that it is already so difficult to time policies to stabilise the economy, what more the stock market? The stock market itself is a leading indicator used to time macroeconomic policies, so surely the investor faces an even tougher task trying to time the stock market.

The other factor to consider is the psychological effect. The market timer who finds that he exited too early may wait until it is really late before plunging back in, thus sustaining a double loss: the opportunity cost of not riding the continued surge after exiting, and then re-entering at the wrong time when sentiment and the market has peaked. It is especially difficult to get out the second time, because the investor is likely not to want to repeat his "mistake" of exiting too early the second time round, and hence is more likely to hold the baby as the market peaks.

Ultimately, like most real-life issues, there is no definite rule and the decision to market-time (or not) is part of the investment mental framework one adopts. For me, I am loathe to lose my positions on my stocks and I am therefore quite resistant to the idea of trying to time the market by selling my holdings and hoping to buy back at cheaper prices later. At the same time, there are many ways to adjust one's positioning depending on his conviction of the market direction, and one way is a more defensive stock allocation eg. shifting preference towards non-cyclical stocks. It also makes sense to have a feel of which stage the economy is along the business cycle (early-stage bull, mid-stage bull, late-stage bull, early-stage downturn etc) and concentrate on appropriate sectors accordingly. This, I guess, is also a form of market timing, but less extreme than liquidating positions completely. However, I am open to doing that should market valuations get seriously out of whack, say the market trades to 20X market-wide PE.

One final note is with regard to calendar effects, exampled by sayings such as "Sell in May and go away", the much-talked about Capricorn effect, and month-end window-dressings etc. Given that the whole world is aware of these calendar effects, when does one start to adjust portfolio in anticipation of these effects? The likelihood is that they will get priced in earlier and earlier, such that in the end it doesn't make sense to attempt to capitalise on it at all. The market is most efficient in pricing in such "phenomena" like these.