Timing the Market

S

SunKing

Guest
Hi All,

Well after much debate with a good friend of mine who is also into investing in the stock market, we've decided that we should try to "do the unthinkable"- attempt to time the market by moving sizeable chunks of our long-term investment portfolio- specifically those that are in broad index funds like the S&P 500 Indiex- out of the market and into cash/low-risk investments, waiting for the next correction to jump back in.

For decades the textbooks have warned NOT to attempt this, but I've come to believe that it is necessary to try, with at least a portion of your long-term portfolio- that the risk of not doing it is at least as large if not larger than the risk of trying to do it (If you want more details on how we came to this conclusion and have a bit of time, I've pasted in excerpts from our last discussion on it below...totally subjective and we're no experts, keep in mind).

My question is: What would you say are the most reliable indicators to judge when the overall stock market (as measured by the S&P 500, to keep it "simple") is overvalued? Average P/E ratio etc.? I welcome your comments.


P.S. Target level for getting out of the S&P 500: 1,170 perhaps? :)


Excerpts from the debate:


I think we should take some very valuable lessons from this latest market meltdown and its aftermath...in fact I think it should indelibly change the way we invest.


During the last 10 years, we've moved increasingly away from from the classic long term buy & hold strategy that Buffett advocated. But this latest insane bloodbath must create a new investment paradigm.

On one level, it's simply the fact that we need to shorten our buy and sell cycles: For many- but not all- stocks we need to buy them and sell them promptly the very first time they reach a target level of appreciation, only months or even weeks/days later. Before my attitude was, buy it undervalued, watch it hopefully climb to being fully valued (back to a more normal Price to Tangible Book ratio and/or P/E to Growth ratio), and hold it for the next few years if the company was solid and still growing earnings. We need to shorten the time horizon- if it climbs to being overvalued, sell it immediately. If it climbs to being fully valued, strongly consider selling it unless you've held for less than 1 year and want to avoid higher taxes by risking a longer hold period. On top of this I think we need to be brave enough to even do some "Ping Pong Pigeon" trading...really short term action where we pull the sell trigger quickly and then buy the stock back again if its volatility has been continuous and you think it will keep swinging up and down. How many times have we regretted NOT selling during the last two years??

OVERALL STRATEGY: THE NEW PARADIGM
What's more significant is the broader picture...regarding our overall strategy, for the bulk of our retirement savings (and primarily our stock index funds). The old guidance we have always heard, over and over again is, "Don't try to time the market.". After this last totally insane MELTDOWN, I'm reaching the following conclusion: We can't afford to NOT time the market...it's risky but in fact it might be our only way to beat the market or even simply to get back to those historic 10% average annual returns over the long term, which were virtually "guaranteed" previously. Here's what makes the reality crystal clear: The shocking truth comes to you when you think back to how many times in the past you could have cashed out your stock index funds which mirror the overall market (S&P 500) and left them in cash, for years, and done much better. Remember how young you were when the DOW first hit 10,000? It was 1999!!! You were only 28!! If someone had said to you that day, "Hey, you should dump your stock portfolio 100% into cash now...", you would have laughed. But think about how many times the bloody market was above the level it sank to in 2008/2009 (below 7,000!). People tend to think about "timing the market" as some insanely intricate, impossible to execute strategy whereby you have to pick one particular day out of several years as the only optimal time to cash out.

This is obviously not the case. The 2008 market meltdown was so extreme and prolonged that it would have been almost hard NOT to choose a good time to cash out and be able to buy back in later at better, lower prices. And I'm not talking about timing perfection, as in, "Wow, I was so brilliant that I cashed in at the very peak (14,000) and waited to buy in at 6,800!" That is of course not achievable. My point is, looking at this chart, it's clear how many times we COULD have cashed out and sat on our money- for YEARS in a safe money market account- and still done better than leaving it in the market the whole time. Let's say you laughed at the idea in 1999. Fine. Look at the chart. You could have decided to cash out at 10,000 or above during 2002, or 2003, or 2004, or 11,000, or 12,000 after 2006....we had YEARS to do this.



Of course, the harder part is knowing when to do this, but with a bit of analysis we can accomplish that- by analysing and selecting the correct macro-level indicators. For example, remember when the DOW was at 12,000+ and there were many articles saying, "The overall market is too richly valued because the average P/E ratio of DOW (or S&P) stocks is 40% higher than what it was during the last four decades"?? We need to select such indicators and then make decent judgments by using them, especially about our stock index funds/ETF's. What makes it harder is that history isn't entirely relevant- the standards are shifting- but we'll factor that into our analysis.

So there you have it...I am saying we need to shorten our trading time horizons and even try large scale market timing moves


BUT HERE'S THE KEY: I think we have to massively re-think how we approach the market...nothing short of a new investment paradigm, inspired by the profound fragility the market has now evinced. The bottom line is, I think we must try to time the market over an extended time period. We've never done this before. In fact, until now, I have always looked upon any cash sitting in my brokerage account as a non-performing asset, a missed opportunity..."Get it back into the market as soon as possible; you're wasting time (and money)!" was how I thought. That's how we were trained to think, but I suggest we end this approach. As I stated earlier, there were SO many times during the last decade when it would have been a GREAT idea actually to sell fully valued stocks and then park the cash in the money market- for a long, long time. I think we should do this with a significant portion of our index funds (which still comprise the largest portion of my total portfolio) when the time is right.

Of course, judging when the market is absolutely peaking- or when it's at its lowest point- is virtually impossible. But we don't have to time perfectly to benefit immensely. Let's say we cashed out at DOW 11,000 years ago instead of DOW 12,000. And then bought back in at 9,000 instead of 7,000 or whatever its meltdown low was. So what- we STILL would have done so much better than sitting there and holding as we have done so far, watching our stocks simply lose almost half their value (and then start a slow, painful path to recovery). We have to decide on some decent broad indicators in terms of market valuation- P/E ratios come to mind as mandatory. When the DOW's back to around 11,000 I am going to at least consider cashing out on up to 60% of my index funds...and leaving them in the money market or at least out of the stock market...possibly for years, and that's what makes the difference...and then diving in all at once, going on a passionate feeding frenzy, when the next meltdown occurs, a bit like what I did in Autumn 2008. The difference is, in Autumn 2008, I was rushing new money into the market only- I had unfortunately not cashed out on any of my fully valued holdings previously- much to our chagrin when CITIBANK AND FRIENDS MELTED INTO A POOL OF WORTHLESS SLIME. One challenging thing with my new approach: That's a lot of pressure, to choose 30K+ of stocks during a short time period..we'll need to take a vacation day from work and go on a rampage basically. And imagine when it's 200K. Gulp.

The next question becomes: What should we do with that money during those years? Segue into Shorty's last statement:

What I propose is that we collectively explore other areas in which we might invest our hard-earned savings. Areas that are ideally a) less popular than common stocks, b) have the possibility of yielding higher returns.
This is a separate topic I reckon but a very important one. For now, whilst we're deliberating, the clear answer is money market. A more sophisticated solution is bond funds, but I must confess I know very little about bonds. Anyway, the need for this new ShortyIndy investment paradigm is immediate- I am already struggling to find compelling buys as the new year begins. Do you have any ideas in regard to alternate investment vehicles? BMW 1602's perhaps? ; )

Indy

Shorty
 
You're whole plan rests on finding an objective measure that tells you whether the market is over or under valued. Unfortunately there is no well known measure for this. You seem to have identified is P/E ratio as a candidate. On the basis of P/E you could have plowed your pension fund into Irish retail banking shares back in 2007 only to have your retirement savings destroyed. Low yield (i.e. P/E) is also associated with highly distressed assets. O.k. for a while "value funds" (i.e. composed of low P/E stocks) seemed to offer a small premium over growth funds but that effect has disappeared in the last 15 years.

However debating P/E is not my main point. It is this; I would be flabbergasted if you and your friend actually derived some macro market measure which had any statistically significant predictive power. In the absence of such a measure you are simply gambling because you are relying on gut instinct and ad-hoc justification for your decisions.

I suggest you try some real trading with a few grand in a futures/financial spread betting account for a few weeks to disabuse yourselves of the notion that there is anything obvious or inevitable about market movements. It will be a sobering experience. Graphs always look obvious when they show the future.
 
Do you want to be a trader or remain an investor???!!!

Jeremy Grantham at GMO wrote a good note about exactly how to invest in and out of the market. I will try and find it.

He basically advocated a large percentage in cash and buy in stages during high volatility.

I am warming to the idea of holding 30% cash or so waiting to invest in a new correction. Nonetheless, 2008 was the worst year on record in terms of markets being down 50%.

How many times in history have markets tanked following such a large correction? One - i.e. 1929-30?

I believe we are in a new bull market that will last many years. As Marc Faber says - Western Governments will run negative interest rates for a decade.

In such an environment stocks and commodities will be the only investments to rise (at least nominally, maybe not in real terms!).

In terms of bonds the only decent ones IMO are emerging market debt. There has been a role reserval in the debt markets. The Western debt market is now a disaster waiting to happen.

Emerging Markets are more solvent and have rising currencies against the bust West. These are the only ones to hold IMO.
 
SunKing said:
So if the DOW hit 13,000 and every reknowned macroeconomist in the country was screaming "overvaluation", you wouldn't move a cent? In the past, I didn't either, and now I'm changing this.
Click to expand...
I don't want to be too negative but have any of these renown macro-economists made fortunes trading and if not, ask yourself why not? Why DOW at 13000? Why not 10000 which was the fashionable DOW number everyone speculated about during the 1990s?

For a relatively small amount of money you can replicate a fraction of your current pension fund using futures with a financial spread betting company. Then try trading it for 6 months or a year - leaving your actual fund alone. At the end compare the returns.
 
Just an interesting point with setting targets for an index is that you could be waiting a while for something you might feel is inevitable.

I remember in late 2005 having made a decent gain on my equity ssia I moved to cash feeling a correction was surely on the way. I missed out on significant growth over the following year and a half and it was late 2008 before markets came back to the level I had cashed out at.

The issue is that you might be right but it takes enormous discipline to stick to your guns in irrational markets
 
SunKing said:
So if the DOW hit 13,000 and every reknowned macroeconomist in the country was screaming "overvaluation", you wouldn't move a cent? In the past, I didn't either, and now I'm changing this.
Click to expand...

One other point is that the indices at any given point are perfectly balanced by the people in the market who are putting their money where their mouths are.

It would be nearly impossible at any given time to have a general consensus of overvaluation or undervaluation.

This fact is lost on people because at the time the DOW is 13,000 there is a 50:50 split of people saying it is over or undervalued. If two weeks later the DOW is 10,000 100% of people will be able to tell you why it had been 30% overvalued and act as if this was plainly obvious when in fact at least 50% of those trading two weeks earlier thought it was good enough to purchase at that level.
 
darag said:
I don't want to be too negative but have any of these renown macro-economists made fortunes trading and if not, ask yourself why not? Why DOW at 13000? Why not 10000 which was the fashionable DOW number everyone speculated about during the 1990s?

For a relatively small amount of money you can replicate a fraction of your current pension fund using futures with a financial spread betting company. Then try trading it for 6 months or a year - leaving your actual fund alone. At the end compare the returns.
Click to expand...

Hi there, I see your point, except with the futures idea- I'm afraid you're talking over my head with that; I'm not familiar with that kind of trading. It's true that it's difficult if not arbitrary when it comes to picking an exit point- Why not DOW 11,000...or 13,000? What about 10,000? The interesting thing is that in previous years we could have cashed out at ANY of those points and still made more money, since many years later the DOW sank all the way below 8,000 in 2008.

Nobody was predicting SUCH an extreme correction. But imagine, even if you had cashed out the first time the DOW hit 10,000- all the way back in 1999....and put it in a conservative bond fund or even the money market. Remember how young you were in 1999? Fack! Anyway, everyone would have called you foolish for doing so, for years. At DOW 13,000 you might even have started believing them. But then, if you stuck to your guns, around 10 years later- you'd have suddenly beaten the market, by buying back in at DOW 8,000 (and after earning interest for 10 years, at the very least!). It's an example worth pondering in terms of future volatility/trends.
 
SunKing,

If you want a metric to look at market risk in the stock market take the current yield on stocks from the yield on 5 or 10 year government bonds. This is basically how CAPM works. So if 5 year German bonds currently yield 3% and the ave (forward looking) P/E ratio of Eurostoxx 50 index is 14 (roughly a 7% yield) the market risk premium is 7-3 = 4%. I've made these numbers up but i think that 3 to 4% is somewhat accurate for major European and US markets at the moment. That would indicate investors are demanding a reasonable risk premium on stocks, i.e. they aren't overvalued.

If you want to do some reading google the PDF link to a book called Margin of Safety by Seth Klarman, a highly successful hedge fund manager over a long time period. Klarman applies principals somewhat similar to what I think your advocating and has historically held large amounts of cash in his fund when he felt market was overheated.

Despite your claims of a new paradigm I'd still recommend value investing for somebody who wants to get involved in managing their own portfolio. Google Ben Graham and buy his books, and find out as much as you can about the methods of other successful value investors, including Buffet.
 
I came across this thread while looking for something else. It may serve as some sort of lesson on the dangers of attempting to time the market as the original poster would have missed out on a 14% spurt of growth by the S&P 500 since they started this thread.
 
SunKing said:
Hi there, I see your point, except with the futures idea- I'm afraid you're talking over my head with that; I'm not familiar with that kind of trading. It's true that it's difficult if not arbitrary when it comes to picking an exit point- Why not DOW 11,000...or 13,000? What about 10,000? The interesting thing is that in previous years we could have cashed out at ANY of those points and still made more money, since many years later the DOW sank all the way below 8,000 in 2008.

Nobody was predicting SUCH an extreme correction. But imagine, even if you had cashed out the first time the DOW hit 10,000- all the way back in 1999....and put it in a conservative bond fund or even the money market. Remember how young you were in 1999? Fack! Anyway, everyone would have called you foolish for doing so, for years. At DOW 13,000 you might even have started believing them. But then, if you stuck to your guns, around 10 years later- you'd have suddenly beaten the market, by buying back in at DOW 8,000 (and after earning interest for 10 years, at the very least!). It's an example worth pondering in terms of future volatility/trends.
Click to expand...

This is just a side issue of the fact that anyone investing in stocks over the last ten years or so has probably not beaten inflation, it's not been a great investment overall. You need to selll out at the right time. Of course you won't hear that from people who depend on the public trading stocks for a living.

Have a look at this stock index from Japan. Things can go down for pretty much forever in an investment horizon.
http://www.thedigeratilife.com/images/japanchart.png


But market timing should be the way to go now, there are few fairly obvious events that could pummel the market, most likely Greek and other euro problems but also Chinese property and US debt, a lot of volatility. No harm to keep cash on the sidelines.
 
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