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.
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.
Caveat emptor: Such sages are a distinct minority. Mark Hulbert, longtime publisher of the Hulbert Financial Digest that tracks roughly 170 market timing newsletters, consistently finds that roughly 80% of newsletters underperform the market indexes. "It's such a constant it's like, end of story, might as well go home," he says.
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."