Some Thoughts On Market Timing
On the front of the site it says that one of the pillars of our process is a thing called “market timing.” It turns out that term is controversial and over time we have gotten a lot of questions about it. Kind of weird tbh as we are clearly fans of active management, and yet here we are. So here are some thoughts on what market timing is, a bit on the controversy, some of the pitfalls, and how we look at it.
How We Define Market Timing
In one sense market timing is synonymous with the term active management. In both cases you are opening a position in XYZ when you think it is a good bet to likely move in your favor, and closing it when you think that at least on a risk adjusted basis it is not as good anymore.
Of course then that gets us to a discussion about if Warren Buffett times the market. The value purists would say that is blasphemy, but we would ask “then why is he sitting on such a massive cash position right now?” Clearly he is not seeing value everywhere he looks, or he would be fully invested or even levered.
When most people think about market timing they are envisioning a guy looking at a chart or a model and saying “I am buying the SP500 right here, and then later selling right there, because he thinks that he can perfectly catch the next move up or down.
While that guy certainly exists, that is not how most practitioners do it. For most people who work on timing, their models tend to be either full of historical factors like valuation, trend, momentum, and carry, and/or they have models with technical, fundamental, sentiment, and economic data in them. And instead of trying to nail the next 3% move in the market, they are trying to better manage their exposure based on how favorable or unfavorable their testing shows the current market to be.
So market timing to us, or at least proper market timing, is the pursuit of managing our exposures based on what has happened in the past, and what we expect to happen in the future, to improve our risk profile and our return profile.
It is not “price closed above this point so go all in, and price went below this point sell it all.” Again, maybe some people do it this way, but we don’t know that person.
What Does History Tell Us
If we are looking at the stock market there are a few things that we know based on the historical evidence.
1-Stocks as a group (not individually) go up over time.
2-Stocks, both as a group and individually, sometimes drop -50% or worse in nominal terms when we have recessions.
3-When the market is super expensive, your random friend who doesn’t know what a stock is starts asking you “how is your portfolio?”, we have an inverted yield curve, interest rates are rising, rate spreads are widening, and we start seeing some of the leaders begin to falter and the trend starts to turn, you usually don’t want to be extremely long or be loaded up in speculative names.
4-When the market is cheap, everyone thinks the world is ending after things have come down -50%, we have a positive sloping yield curve, the Fed has cut rates several times, spreads are tightening, and stocks start to move up, it is usually a favorable time to be long, or to be longer.
History shows that over a cycle a static allocation is rarely anywhere close to optimal, and that adjusting your exposure to the changing risk backdrop can lower your risk and sometimes increase your returns as well.
Time In The Market vs Timing The Market
Personally I hate this saying as it comes from marketing when wealth management started to move from a commission based model to an assets under management model. It can seem hard to justify paying an AUM fee when 50% of your money is just sitting in cash doing “nothing.” So wealth management had to come up with a nifty slogan to sound smart.
Then there is the “if you miss the best 10 days” thing. They show that missing the best 10 or 20 days of the market will kill your performance. And this is accurate…but unless you also show the other side it is also misleading. What if you miss the worst 10 or 20 days? And what if you miss the best and the worst 10 or 20 days?
Turns out that the risk reduction is better than the return enhancements, and that while not perfectly predictable, almost all of the best and worst days happen in downtrends as volatility increases, and trend following is possibly the easiest factor to capture.
So while we are not saying everyone should be trying to catch the next 3% move up or down, we do think that over time you can drastically enhance the risk adjusted returns of a portfolio by engaging in back testing, model building, and applying a market timing framework to your investing process.
A great paper Where the Black Swans Hide & The 10 Best Days Myth was done by Meb Faber back in 2011 and is worth reading.
Conclusion
We can go on for days about this. Clearly we think that a lot of the ways that people view “market timing” is flawed. Most of the time you should be mostly long beta, but you can do a lot of things at the edge to lower your risk profile. And that is something that we do believe in.
In future posts we will go over some different studies, model building, etc. As with most things in this business it is not easy, but also not as hard as we usually make it, and if you work at it harder than others you can usually find something useful.
Happy Trading,
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