What does "Timing the Market" or "Market Timing" Really Mean?

"Timing the market" is considered by many to be a foolish exercise.  Timing the market is indeed foolish if it is done the way many seem to think it is done.  However, it is really a matter of having a good sell strategy or stop loss system coupled with a good buy strategy.  Expert timers do not buy because they feel a stock is a "good" one to own, or sell because they feel it is "high."  They buy because there has been a buy signal, and they sell because there has been a sell signal.

Some writers in the financial media color their articles with their own uninformed opinions rather than search out the facts.  Let me give you an example of what I mean.  In a recent well-known financial publication, a widely followed writer wrote about "market timing" and said that it has taken on a new meaning that differs markedly from the original meaning of the term.  The term "market timing" has been used in reference to how some individuals trade mutual funds by illegally locking in an unfair price advantage and profiting on small pricing gaps between markets in different time zones.  The writer mentioned above informed the reader that in the original definition, market timing involved shifting money into cash or bonds when the investor thinks stocks are overpriced and moving back into stocks when he or she thinks they are cheap. This author was correct with regard to the changing of the definition.  However, he then went on to say what he thinks is wrong with the original timing concept.  

The problem is that he leads his readers to assume timing decisions are based on what the timer "thinks" about the market and economy and what he believes "ought" to be the influence of such an environment on investments.  This indeed appears to be the way most amateurs and some under-performing professionals practice "timing."  Fund-provided data does show that there is more money flowing into funds at market highs and more withdrawals at market lows, reflecting how most people attempt to "time" their investments. This does show that, as a group, they are almost always wrong.  In fact, that's why there is such a thing as a "contrary market indicator" based on what the small investor is doing.  It is an odd-lot volume indicator based on the fact that the small investor tends to increase his buying at the highs and increase his selling at the lows.  Therefore, when there is mounting odd-lot buying (individual investors are "feeling good" about the market), professionals view it as a warning signal of an impending market downturn.  

However, it is a fallacy to use this data to claim that it proves timing doesn't work. There are many excellent timers.  Most professional "timers," the people who do it successfully, do not base timing activities on how they "feel" about the market.  For example, stockdisciplines.com traders generally do not say to themselves, "Interest rates are likely to rise, therefore I will avoid fixed-income investments because they will likely drop in value."  While the idea is strategically sound in this case and the proposed course of action is correct, this thinking process does not resemble the way the most successful market timers make their buy and sell decisions.  While there are some who base decisions on such things as their evaluation of the economy or the effect of war on oil prices, most of the highly successful timers use a variety of technical indicators and focus on the current status of the market (what IS) rather than on what they think the market is going to do next.  "Do we have a current sell signal or not?"  Opinions about whether stocks are too high or too low have little to do with such strategies.  For them, quantitative data, technical indicators, and action signals are the bases for their decision-making.  

Let me illustrate with a few simple timing models.  Let us assume your goal is to capture the best returns you can by investing in any sector or market on the planet.  To do this, you might decide to give your attention to ETFs.  Therefore, you might rank all ETFs in the order of their strength.  Assume that you have a way of measuring, as our model does, more persistent strength than that measured by the RSI.  Your timing model might then be expressed as follows.  You will buy the 10 top ranked ETFs.  Then, you will sell any ETF that drops out of the top 30 and replace it with the highest ranked ETF in the top 10 that is not in your portfolio.  Assuming your collection of ETFs represents a wide variety of sectors and markets both domestic and foreign (and includes U.S. index ETFs), and assuming you are always invested in the strongest of the strong, your portfolio should significantly outperform the U.S. stock market.  

Another example of a simple timing system might be expressed as follows.  You will buy an undervalued stock when it closes above its 150-day moving average but only after that average has begun to rise.  You will sell if the stock closes below its 150-day moving average but only after that average has begun to decline.  A 10-day moving average or some other moving average might be used instead of the closing price in order to reduce whipsaw effects, and other moving averages could be used instead of the 150-day average, depending on the individual's investment time-horizon.  Here, the idea is to be invested in the stock during most of any up-trend and in cash during most of any downtrend.     

There is no "feeling" involved in the decision process of either of these timing models.  In actual practice, both of these models might be enhanced with other rules and supported by other indicators to reduce false signals.  The "timer" is not interested in what the market "ought" to do next.  He is interested only in what "is."  The most consistently profitable timers simply obey the rules of their model.  For example, either an ETF has fallen out of the top 30 ETFs or it has not.  If it has, it must be replaced.  There is no anxiety-ridden decision process here.  The successful timer just does it.  Why the ETF has fallen out of the top 30 is not important.  There are forces at work in the marketplace that no single individual can know completely.  Whenever an ETF falls out of the top 30, it is replaced by another ETF.  For some reason, that other ETF has become supported by more consistent buying power.  It is the flow of money that causes "strength."  Top timers using this model would simply follow the money by going where the strength is.

After years of high volatility, it has become apparent to an increasing number of investors that some form of timing is a more credible approach to investing than the old buy-and-hold strategy.  Many experts agree that increased volatility means active trading could be the best way to make money in coming years because trends will be shorter-lived.  This is not to imply that investors should become day traders.  The spectrum of traders is broad.  Some traders may indeed hold an individual stock for a long time.  The point is that having a well-defined sell strategy and implementing it will probably be the best way to make money in volatile markets.  Though volatile markets can make it easier to make gains, volatile market also tend to take those gains away.  It is not your tally of paper profits, but what you can keep in your account that counts.    The concept that "buy and hold" is the safe way to invest has become very misleading to the public.  People who bought and held LA Gear through a prolonged decline until it simply disappeared understand that.  After the crash of 2000, investors seemed to appreciate the value of having a stop loss strategy, but a few years later they apparently forgot the lesson.  Increasingly, people seen to be proud of the fact that they never trade their stocks because they are "long-term investors." What the term "long-term-investor" has come to mean is "I do not really have any sell strategy or use stop losses."  While it is well to be a long-term investor in the general sense, being a long-term investor in any individual stock has the potential of becoming a painful and costly learning experience.  Those who do not adhere to a set of rules for selling are begging the market to teach them the lesson again.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com