Successful Market Timing – It Requires Two Correct Actions

Tuesday, January 19, 2010

01-19 859877_traffic_sign_30-200After a major market drop, news comes out about the people who saw it coming and got out. There are always a few that do. The elements align to their way of thinking, and they look brilliant. But that’s not the end of the story. Those stars must then decide when to get back in, and that’s a problem.

Financial advisers often dismiss market timing as a viable strategy, and for good reason. Unlike a stock manager focusing on company fundamentals, a market timer must traverse all markets and economic sectors, adding in doses of political, corporate and consumer insights. From that milieu can come an “ah-ha!” moment when the market timer spots a trend’s turn. But that is an infrequent event. Too often “ah-ha!” turns into “oh-oh!” as the trend keeps on going.

What I want to discuss is the exceedingly difficult second call. Even if calling the top successfully, the investor, once out of the market, must decide when to re-enter. Timing a drop and avoiding losses may seem fantastic, but that very success can trip up the investor later.

I thought examples would be the best way to convey the problems. Here are three examples from my first-hand experience of knowledgeable, wise and successful investment managers getting entangled with market timing:

The first example is from the major 1973/1974 bear market. A New York City investment management firm called the market top well, avoiding much of the decline. The problem was their success and notoriety made them wary of buying back in – they knew all the risks and problems, so had trouble dismissing them. Finally, after the market had risen well off the bottom, they threw in the towel and bought back in. One partner, though, was convinced the market would reverse its climb and plunge to new depths (like what we are hearing and reading about today). He had clients that were stalwart believers, so he was able to set up his own firm. His start was auspicious: He held a gala opening at his new, plush offices, and he was the talk of the pension fund world. A couple of years later, with the market having steadily risen, his old firm was doing fine, but he was out of business.

A second example occurred in the late 1970s/early 1980s when oil stocks were the market favorites and represented over 20% of the Standard & Poor’s 500 Stock Index. A company hired a “guru” to handle their pension fund. The manager had made two dazzling market timing calls at his previous position. However, at the new firm, he failed miserably. He decided oil was due to drop, so he sold it all, only to see oil stocks shoot higher and higher. Finally, he was dragged back into the oil stocks, buying an oversized allocation and using small, risky oil and oil service companies. He was trying to make up for his poor performance. Instead he bought at the top and suffered large losses. After the oil stocks tanked, he was out and his reputation as a market timer was shot.

Last is an interesting example of a manager who saw the 1987 crash coming and got out in time. (This manager was not a market timer, and this was a one-time action.) Because that drop was technically driven and over quickly, he kept his wits and got back in near the bottom. So far, so good. But then in 1988 he began to see reasons for another drop and started raising cash – in other words, he was hooked on the idea of spotting the next market decline. He was an excellent stock manager that I was using at the time. I attempted to get him to reduce the cash in our account, but he couldn’t bring himself to do it, so I replaced him. The market continued to climb, his performance record deteriorated, and he retired a while after that.

These stories show, first, that market timing is difficult. Second, even when done correctly, it can be a curse – even to professionals. The gains made from the hard work of finding securities, building a portfolio and making buys and sells correctly can be completely undone by a bad market call – or a missed second call.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

January 2010