Can You Time the Market?

After watching 70% of his retirement savings evaporate in the 2000-02 bear market, Bob Parrish was determined not to leave what was left to the mercy of the investing gods. So he fired his financial adviser and decided to try something most experts say you should never do: time the market. "Most people thought 2000 was the beginning of a secular bear market," says Parrish, using a term that describes a prolonged downturn. "People said you could still make money, but instead of buy and hold, you had to take a different tack." So he vowed to buy only when he thought the market was headed upward and to bet against it at other times.

Parrish, a retired human-resources executive with an MBA, is no babe in the woods when it comes to finance. He caught most of the market's gains from 2003 to 2005, turned bearish a bit too early in 2006, and with a portfolio entirely invested in bear-market mutual funds (which gain value when the stock market tumbles), he doubled his money in 2008. Since 2002, he reckons, his portfolio has gained an annualized 23%. "While everyone else has been crying in his beer, I've been a happy camper," says Parrish, 64, who lives near Sacramento, Cal.

Parrish's disenchantment with traditional buy-and-hold investing is understandable, given recent results. If ten years ago you had invested $10,000 in a low-cost mutual fund that tracks Standard & Poor's 500-stock index, stuck with it and reinvested dividends along the way, you would have been left with just $8,416 as of May 31. No wonder many restless investors (and more than a few advisers) are dismissing buy and hold as something that works during long bull markets, such as the one that began in 1990 and ended in 2000, but not now. "Buy low, sell high has two parts, and most of the world focuses on just the first part," says Will Hepburn, a Prescott, Ariz., money manager and president of the National Association of Active Investment Managers, whose 200 or so members practice a variety of alternatives to buy-and-hold investing.

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Certainly, if you could master the second part of Hepburn's equation -- knowing when to get out -- you, like Parrish, would be sitting pretty. A chart on Hepburn's Web site shows that if you had owned the S&P 500 from 1983 through 2003, but somehow managed to miss the 30 worst days during that period, you would have earned an annualized 19%, almost double the 10% buy-and-hold return.

Easier said than done. While we agree that there's plenty of evidence that market timing has worked over short and even long periods, the devil is in the details. It's a tougher strategy to pull off than buy and hold, and few do it well. Even Parrish, who has made it work, admits, "I'm savvy enough to recognize I've been very fortunate and that it's not going to last."

Our take on timing

Mark Matson, a Cincinnati money manager, likens a market-timing strategy of switching between stocks and cash to "playing Russian roulette with two bullets in the chamber. The idea that some market timer is going to save you from the crashes while getting you all the upside from great markets is a fantasy."

We're not as dead set against market timing as Matson, but neither are we ready to throw in the towel on buy and hold. We think buy-and-hold investors could incorporate some mild forms of market timing to improve their results. But first, let's take a closer look at market timing to see why it is so alluring to frustrated buy-and-hold investors.

Successful market timing requires three key ingredients: a reliable signal to tell you when to get in and out of stocks (or bonds, gold and other types of investments), the ability to interpret the signal correctly and the discipline to act on it. The popular image of market timing is that it calls for making drastic, all-or-nothing moves into and out of a particular market.

In reality, many timers adjust their investments in stages, and their recommendations don't always reflect such a black-and-white view of things. And while some timers may trade frequently, others use signals that rarely change from buy to sell or vice versa. In any case, timers say that being out of the stock market during its most uncertain periods results in a smoother ride for your portfolio compared with a buy-and-hold approach.

Three kinds of signals

Academics and economists claim to have discovered a number of signals that have proved surprisingly predictive of market turning points in the past. The indicators fall into three broad categories:

Yields and valuations. Pu Shen, a former economist with the Federal Reserve Bank in Kansas City, Mo., has found that an effective trigger point seems to be when the difference between the S&P 500's earnings yield (earnings divided by price) and the yield of either short-term or long-term Treasury securities reaches certain extremes. Using that measure as a signal to switch between stocks and cash on a monthly basis, an investor could have turned $1,000 into $66,000 (using long-term rates) or $101,000 (using short-term rates) over a 30-year period that ended in 2000. A buy-and-hold strategy would have yielded $47,000. (These figures don't include costs such as trading commissions and taxes.)

Market breadth. Dan Sullivan, whose newsletter, The Chartist, has a good long-term track record of market calls, says that when advancing stocks outnumber declining stocks by two to one over a ten-day period, it's a buy signal that works "just about every time." The signal has flashed "buy" just 11 times since 1949, says Sullivan, most recently on March 23.

Moving averages. Many professional timers use moving averages of daily prices as a signal. Take, say, 100 days of closing prices for a stock index, calculate the average of those prices and plot the point on a graph. Each subsequent day, calculate a new 100-day average and plot another point. (A number of charting Web sites, such as StockCharts.com, will do the hard work for you.) You ultimately end up with a line that distills market movements and reveals a trend. Many technical analysts (who make judgments based on price and trading-volume data) believe that when a line of daily closing prices moves above its long-term trend line, it signals that it's time to buy; when the price chart moves below the long-term trend line, it's time to sell.

Unfortunately, a long list of caveats accompanies all of these signals. First, although powerful computers can sift through mountains of market data and find strategies that would have worked in the past, it doesn't mean they'll work in the future. For example, many experts believe the relationship between the S&P 500 earnings yield and interest rates that economist Shen observed breaks down when rates are unusually low, as they had been until recently. "There's no such thing as a perfect indicator," says Sullivan, 74, who began publishing his stock newsletter in 1969 and manages about $200 million in assets. "They tend to change over time." Sullivan says he uses five other proprietary signals in addition to the ratio of advancing to declining stocks.

In general, be wary of any strategy with little to recommend it other than so-called back-tested data. If a market timer hasn't actually produced those outstanding returns, preferably with his or her own money on the line, move on.

And given that the signals themselves are less than perfect, a lot is riding on the person who interprets them. While some timers buy or sell reflexively based on a predetermined signal, others rely on multiple signals combined with their own judgment. "I have learned over the years that you're tracking a person," says Dave Garrett, founder of TimerTrac.com, which documents the buy-and-sell calls of more than 200 timers. "They're going to tweak their systems and change them constantly, and you're never going to keep up with that." Garrett, who uses the buy-and-sell recommendations of some of the timers he tracks to manage money for his clients, recommends spreading assets among four or five timers rather than risking too much on one.

Finally, if you're thinking of timing the market yourself, rather than hiring a professional, consider this: Buying or selling when everyone else is doing the opposite may sound easy, but it's not. "Once you get into market timing, it changes from an investing game to an emotional game," says Garrett.

Pitfalls of being wrong

Remember how Hepburn's chart shows that you could have nearly doubled your buy-and-hold returns by missing the market's worst days? Another portion of the same chart shows that if you missed the 20 best days over the period, your buy-and-hold return would have been sliced in half, to 5% annualized.

Adam Bold, head of the Mutual Fund Store, a nationwide network of advisers based in Overland Park, Kan., speculates that many timers missed the 2,200-point rally in the Dow Jones industrial average from March 9 through June 5. And having done so, they now face a quandary. "It's emotionally hard to get back into the market 2,000 points higher," says Bold. "You may say you'll buy when it comes back down, but what if it never comes back down?" Parrish, the retired executive, recalls battling his own emotions after betting against the stock market as it was rising during the first three quarters of 2007. "It wasn't easy for me to see my portfolio sliding downward," he says.

Mark Hulbert, whose newsletter, the Hulbert Financial Digest, has tracked the performance of investing newsletters for almost 30 years, counts nearly two dozen portfolios that have beaten the market, after adjusting for risk, over the past 15 years. But for some it hasn't been a smooth ride.

Newsletter editor and radio host Bob Brinker, for example, correctly called the market top in 2000 and turned bullish not long after the bottom in late 2002. But he didn't get out of the way of the 2007-09 bear market, and his model portfolios lost an average of 25% over the past 12 months through May 31. He still beats the market over the long term. But how many do-it-yourselfers would have the fortitude to stick with their strategy after a loss like that?

Granted, many buy-and-hold investors also abandon their strategies when the going gets tough and wind up engaging in an unintentional form of market timing. But here's something else to weigh: The stock market's miserable performance over the past decade -- an annualized loss of 1.7% -- comes on the heels of the nifty '90s. During that decade, the S&P 500 gained an astounding 18% a year. In the '90s and the aughts, results diverged dramatically from the stock market's long-term return of 10% a year.

Who knows whether or when we'll see long-term, double-digit average stock returns? But if we do, despite widespread antipathy toward buy-and-hold investing, patience will be rewarded.