Time To Reappraise Market Timing

Some say it's a diamond in the rough; others see fool's gold.

Market timing already carried enough negative baggage before New York state Attorney General Eliot Spitzer last year charged Canary Capital Partners with colluding with Bank of America's Nation Funds to allow it to make rapid-fire timing trades of international funds. But as the tip of the iceberg, if not the proverbial canary in the coal mine, to a broader scandal about after-hours late trading ultimately involving a who's who in the mutual fund industry, it further reinforced the notion, perhaps unfairly, that market timing represents the seamy underbelly of investing.

But does it? Unlike the classic asset allocation model that seeks a desired risk/reward profile by periodically tweaking a group of diversified holdings that are bought ostensibly for the long haul, market timers jump in and out of positions more aggressively in response to changing market conditions. This can range from hyperactive day traders to people who leave the market entirely and sit on cash for longer periods of time to avoid bearish conditions. Although the preponderance of evidence suggests investors can't beat the market averages over the long term, a handful of timers manage to outperform the broad indexes. More than a few of them tout their successful techniques (often inaccurately) on Internet sites and in financial publications, enticing investors who aren't satisfied with merely matching the market.

But Hulbert adds that it's not the end of the story, because we're not statistical, rational robots. Buy-and-hold index funds are ideal for people with the discipline and predisposition to stay the course through thick and thin. Unfortunately, many people panic during bear markets and dump losing holdings, often doing more harm than good to their portfolio. "They end up being worse off than someone following a statistically inferior strategy, but who's willing to follow that through an entire market cycle," says Hulbert.

Dalbar Inc., a Boston-based financial market research company, released a study two years ago showing that mutual fund investors tend to lose their shirts through market timing because many ultimately pursue a buy-high, sell-low strategy that chases winners in bull markets and dumps laggards in bear markets. During a 19-year period from 1984 through 2002, Dalbar found the average equity investor earned an anemic 2.57% annually, versus an average inflation rate of 3.14% and an annual return of 12.22% for the S&P 500.

Admittedly, it was tough to maintain a buy-and-hold strategy after the market tanked in 2000. "Probably 90% of buy-and-hold investors you ask weren't happy with that philosophy during much of the past five years," says Chris Johnson, managing quantitative analyst at Schaeffer's Investment Research in Cincinnati. "Market timers were very happy with a market like this."

At least successful timers were. Schaeffer's takes an options-based timing approach that gauges investment sentiment by tracking such indicators as the amount of cash in the market and the put/call ratio, along with analyst recommendations and investor polls. When optimism is high (i.e. too much cash in the market and a high call-to-put ratio, indicating there's not much fuel left to propel stocks higher), they turn bearish. When the opposite occurs, they're more bullish.

Through its various electronic alert services and a handful of newsletters, Schaeffer's makes anywhere from 24 to 60 trade recommendations a year. Depending on the advice, investors can go long or short, or they can hedge their positions with simultaneous long and short positions, or they can go completely in or out of the market in the case of the options service on the Nasdaq 100 QQQ exchange-traded fund, the Triple Q Speculator.

From June 1, 2002, through June 30 this year, the Triple Q Speculator was Schaeffer's top-performing alert service with cumulative returns of 747%. During that time, cumulative gains among Schaeffer's four trading program areas ranged from 7.4% for put selling to 21.5% for options buying (versus a 5% gain for the Nasdaq Composite and a 0.6% loss for the S&P 500). The company estimates its accuracy rate for the recommendations in its options buying program at less than 40%. The focus is less on winning percentage and more on overall returns, with the idea being to limit losses and let the winners run.

Ultimately, says Johnson, it's as much about profiting from a market move as it is about protecting against a market move. He adds that market timing and buy-and-hold don't have to be mutually exclusive. "The best route is to do both," he says. "Investors can set aside 10% to 20% of their portfolio and use that to time the market."

Some market timing services base their signals solely on nonhuman factors. Timing Cube in Austin, Texas, generates between three to five trading signals a year from market-driven computer models aimed at removing emotion from the equation. "People always tell us that no one can predict the market," says Timing Cube cofounder Serge Dacic. "We're just listening to what the market is telling us, and we follow the trend and invest with it."

Believing that a traditional buy-and-hold approach increases risk by inducing investors to gut it out during significant market downturns, Timing Cube follows prevailing long-term trends mainly based on price and volume action on the Nasdaq Composite index. Depending on the trend, Timing Cube suggests investors should either jump completely into the market, jump ship entirely or hedge their portfolios by taking long and short positions at the same time. Their vehicles of choice are exchange-traded funds and mutual funds that track the Nasdaq 100, Russell 2000 and S&P 500 indexes, which Dacic says provides enough variable performance to create diversified trading opportunities.

Since it began in June 2001, Timing Cube has generated 10 trades, with the average signal lasting 105 days. The shortest signal was just three days. The longest signal was a 393-day buy sign that ended this past April, when Timing Cube issued a sell call in anticipation of a correction based on several factors- indications of institutional selling after prices fell on higher volume following strong earnings reports, interest rate concerns and geopolitical fears.

During its three-year existence, Timing Cube has generated profits in all four of its trading strategies, which entail a mix of long-only and long-and-short positions. Returns range from a 43.73% cumulative gain on a long-only position on the S&P 500 (versus a 6.12% loss on a buy-and-hold position on that index) to a 712.81% cumulative return on its long-and-short-with-margin position on the Nasdaq 100 (versus a 11.41% loss with buy-and-hold). To date, Timing Cube's signals have been profitable 73% of the time across its various trading strategies.

Timing Cube's infrequent signals and overall track record appeal to Dave Garrett, who licenses the service for his $20 million money management firm in Salt Lake City. In addition to Garrett Capital Management, Garrett also oversees TimerTrac.com, a Web site that tracks roughly 400 timing signals so subscribers (financial advisors are a target market) can pick and choose services for their clients' portfolios.

Garrett, an unabashed timer who manages accounts for ten advisors, licenses as many as eight timing services at a time to help manage his clients' money. If one of his partner advisors likes a particular timing signal, Garrett will license it to use for his firm. He's more concerned with avoiding market tumbles than handily beating the market indexes, although his roughly 11% average annualized returns since 1999 beat the averages during that time.

Garrett admits that market timing is a tough sell to advisors because of its very nature: it works best in down markets, but markets historically are up about two-thirds of the time. He explains that timing tends to perform better in bear markets because investors run to cash, the market sinks for a prolonged period, and timers can be heroes by avoiding huge downturns. The trick is getting back in before prices get too high and exceed the initial selling prices.

Conversely, downturns during bull markets are generally short-lived, creating situations where investors sell and then get back in at higher prices than where they cashed out. Considering that bullish markets typically last longer, that presents more opportunities for timers to get head faked into wrong positions.

It doesn't take much to set back a portfolio's long-term performance with a wrong call. According to Ibbotson Associates in Chicago, the hypothetical value of $1 invested in the S&P 500 from year-end 1983 through 2003 earned $11.50 (versus $2.71 for the S&P 500 minus the best 17 months during that timeframe). That same dollar invested in the S&P 500 in 1925 would've gained $2,285 (versus $17.42 minus the best 37 months).

That's a powerful argument for anti-timers, though pro-timers tend to brush off such figures. "Timing is an emotional topic," says Garrett. "It evokes almost religious-like responses on both sides of the issue."

Count Bert Whitehead among the more evangelical anti-timers. "Timing systems, like gambling systems, will end up on the shelves of history along with the theories of alchemy," says the founder of Cambridge Advisors in Highland, Mich. "It seems that most people in the financial community believe the myth that people can predict what stocks will do."

Whitehead follows a strategy he calls functional allocation, which comprises stocks, bonds and real estate. Setting aside 10% of a person's income in a 50-50 mix of stocks and bonds that earn market returns, over a long period of 30 years or so, should provide enough money to live off, he says, while real estate is the "wild card" that can really boost a person's portfolio.

Mark Hulbert is officially agnostic regarding market timing, but he acknowledges that statistics prove a handful of people can do it successfully to a certain degree, and that a few do it better than most. The failure of the majority reflects the difficulty in beating an efficient market that represents the input of the masses. "Markets incorporate a lot more information than any one person can bring to the table," he says. "When you put it all together, it's very difficult to beat the house."

But whether it's Las Vegas or Wall Street, people will always try to beat the house. And with investing, short-term inefficiencies provide tempting opportunities to hit the jackpot. "Our position isn't that market timing can't potentially add value," says Peng Chen, Ibbotson's research director. "Our position is that market timing requires superior skills, and that most people-including many professionals-don't have those skills."