market timing

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Broad definition of market timing

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.

Differing views on the viability of market timing

Whether market timing is ever a viable investment strategy is controversial. Some may consider market timing to be a form of gambling based on pure chance because they do not believe in undervalued or overvalued markets. The efficient-market hypothesis claims that financial prices always exhibit random walk behavior and thus can not be predicted with consistency.

Some consider market timing to be sensible in certain situations, such as an apparent bubble. However, because the economy is a complex system that contains many factors, even at times of significant market optimism or pessimism, it often remains difficult, if not impossible, to pre-determine the local maximum or minimum of future prices with any precision; a so-called bubble can last for many years before prices collapse. Likewise, a crash can persist for extended periods; stocks that appear to be "cheap" at a glance can often become much cheaper afterwards before either rebounding at some time in the future or heading toward bankruptcy.

Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka, mutual funds. Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a buy-and-hold strategy with periodic "rebalancing". But what is this rebalancing if not a point-in-time decision to react to the movements in the market?

Brokerages may favor institutional investors at the expense of smaller retail investors

Perhaps consistent with these two opposing views is that, as with any type of trading, market timing is difficult to carry out on a consistent basis, particularly for the individual investor unschooled in technical analysis. Retail brokers are also generally unschooled in both the mind set and the tools needed to successfully time the market, and indeed most are actively discouraged by the brokerages themselves from moving their clients in and out of the market. However, as market makers, many of these same brokerages take the opposite approach with their large institutional clients, trading various financial instruments for these clients in an attempt to "predict future market price movements" and thereby make a profit for the institutions. This dichotomy in the treatment of institutional vs. retail clients can potentially be controversial for the brokerages. It may suggest for example that retail brokers and their clients are discouraged from market timing, not because it doesn't work, but because it would interfere with the brokerages' market maker trading for their institutional clients. In other words, retail clients are encouraged to buy and hold so as to maintain market liquidity for the institutional trading. [this para makes no sense whatsoever] If true, this would suggest a conflict of interest, in which the brokerages are willing to sacrifice potential returns for the smaller retail clients in order to benefit larger institutional clients.

The 2008 decline in the markets is instructive. While many retail brokers were instructed by their brokerages to tell their clients not to sell, but instead "look to the long term", the market makers at those same brokerages were busy selling to cash to avoid losses for the brokerages' large institutional clients. The result was that the retail clients were left with huge losses while the institutions fled to the safety of short term bonds and money market funds, thereby avoiding similar losses.

Curve fitting and over-optimization

A major stumbling block for many market timers is the phenomenon of curve fitting. This means that a given set of trading rules has been over-optimized to fit the particular dataset for which it has been back-tested. Unfortunately, if the trading rules are over-optimized they often fail to work on future data. Market timers attempt to avoid these difficulties in a number of ways. One is by looking for clusters of parameter values which work particularly well^[1]. Another is using out-of-sample data, which ostensibly allows the market timer to see how the system will work on unforeseen data. However, critics charge that once the strategy has been revised to reflect such data it is no longer "out-of-sample".

Independent review of market timing services

Several independent organizations (e.g., Timer Digest and Hulbert Financial Digest) have tracked some market timers' performance for in some cases over thirty years. In many of these cases, they have found that purported market timers do no better than chance or even worse. However, some have proven to be reliable for the entire thirty year period with performances that substantially exceed the performance of the general stock market or the sectors that the market timer invests in. Jim Simons Renaissance Technologies Medallion Hedge Fund has consistently outperformed the market. The fund allegedly uses mathematical models developed by Ellwyn Berlekamp.^[2] Efficient market theory has also been criticized as an unscientific theory. That is, it assumes the null hypothesis is true (nothing can predict the market), which is the reverse of standard Popperian methodology.^{[citation needed]}

A recent study suggested that the best predictor for a fund to consistently outperform the market was low expenses and low turnover, not pursuing a value or contrarian strategy.^[3] However, other studies have concluded that some simple strategies will outperform the overall market.^[4] One market timing strategy is referred to as Time Zone Arbitrage.

Scandal wrongly tainting legitimate market timing

A scandal erupted in the United States in 2003 where some mutual funds "secretly" allowed select investors to rapidly trade the portfolio despite statements banning the practice in the prospectus.^[5] The scandal did not involve market timing per se, and market timing is not itself illegal. The scandal involved permitting selected investors to make frequent and repeated trades during the day while permitting general investors to trade only at the close of business, which permitted the favored investors to take advantage of market timing strategies. A double standard that favors one investor at the expense of another is illegal and undermines the credibility of the industry"^[6] In this instance, the market timing frequently involved predictions of the performance of how international markets would respond to the day's trading in the US. This scandal also involved late trading.

Although the illegal activities of this scandal had nothing to do with legitimate market timing, some in the brokerage and mutual fund industries have nevertheless attempted to link the two. While the motives for doing this remain unclear, one view is that doing so is consistent with the industries' long held view that retail investors should avoid trading and instead buy and hold, despite the potential for market losses.

Evidence against market timing

Mutual fund flows are published by organizations such as Investment Company Institute and TrimTabs. These show that flows generally track the overall level of the market. For example, in the beginning of the 2000s, the largest inflows to stock mutual funds were in early 2000 while the largest outflows were in mid 2002.^[7] It is good to note that these mutual fund flows were near the start of a significant bear (downtrending) market and bull (uptrending) market respectively. A similar pattern is repeated near the end of the decade.^[8]

This mutual fund flow data would seem to indicate that most investors (despite what they may say) actually follow a buy high, sell low strategy.^[9] Studies confirm that the general tendency of investors is to buy after a stock or mutual fund price has already increased. This creates a surge in the number of buyers which then drives the price even higher. However, when the supply of buyers becomes exhausted, the demand (supply and demand) for the stock declines and the stock or fund price also declines.^[10]

The famous Dalbar study found that the average investor's return in stocks is much less than the amount that would have been obtained by simply holding an index fund consisting of all stocks contained in the S&P 500 index.^[11]

The efficient-market hypothesis (EMH) says that market timing strategies can not work. It says that investors can't "beat the market"; interestingly, it says that investors can't do worse (on average) than the market either. EMH says that the investment return created by a strategy that is 50% of the time in cash and 50% of the time in stocks should be similar to a strategy that is 50% invested in stocks and 50% in cash at all times (plus variations for random error).

What some financial advisors say

Financial advisors often agree that investors have poor timing, becoming less risk averse when markets are high and more risk averse when markets are low.^[12] This is consistent with recency bias and seems contrary to the acrophobia explanation. "The only problem is that, unlike Mr. Spock of Star Trek fame, humans are not entirely rational beings."^[13]

Proponents of the efficient-market hypothesis claim that prices reflect all available information. EMH assumes that investors are highly intelligent and perfectly rational. However, others dispute this assumption. In particular, proponents of behavioral finance claim that investors are irrational but their biases are consistent and predictable.

See also

• Stock market cycles
• Stock market bottom

References

1. ^ Pruitt, George, & Hill, John R. Building Winning Trading Systems with TradeStation(TM), Hoboken, N.J: John Wiley & Sons, Inc. ISBN 0471215694, p. 106-108.
2. ^ Finance and Business
3. ^ Malkiel B.G. (2004) Can predictable patterns in market returns be exploited using real money? Journal of Portfolio Management, 31 (Special Issue), p.131-141.
4. ^ Shen, P. Market timing strategies that worked — based on the E/P ratio of the S&P 500 and interest rates. Journal of Portfolio Management, 29, p.57-68.
5. '^ 'See, e.g.http://www.sec.gov/litigation/litreleases/2006/lr19724.htm (describing the S.E.C.'s settlement with Kenneth W. Corba, the former chief executive officer of PEA Capital LLC).
6. ^ Hougel, T., & Wellman, J. (2005) Fallout from the Mutual Fund Trading Scandal. Journal of Business Ethics 62, p.132 & p.129-139.
7. ^ Global Equity Strategy
8. ^ Worldwide Mutual Fund Assets and Flows, Fourth Quarter 2008
9. ^ If You Think Worst Is Over, Take Benjamin Graham's Advice
10. ^ Dumb money: Mutual fund flows and the cross-section of stock returns
11. ^ Fact Sheet: Morningstar Investor Return
12. ^ Switching to Cash May Feel Safe, but Risks Remain
13. ^ WHY INVESTORS DON’T BEAT THE MARKET

External links

• Market-Timing Strategies that Worked
• [1] Timing Examples