The siren song of market timing persists despite overwhelming evidence that most who attempt it fare poorly. With two punishing bear markets fresh in recent memory, investors can be forgiven for wanting to avoid the next big downturn.
This analysis offers an alternate path to trying to time the market yourself, a path which we believe will produce both better long-term results and greater peace throughout your investing journey.
Market timing, commonly understood as attempting to sell stocks when the market is near a high and buying back in when it is near a low, has fallen into disrepute in recent decades. Many voices, SMI’s included, have warned investors to avoid trying to time the market, usually on the basis of one or the other of two main arguments. The first is to argue that successful market timing is too difficult (and rarely succeeds, even among professionals). The second concedes that successful market timing is possible but extremely difficult for most investors to achieve due to the enormous emotional burden involved.
In this article, we are going to make a more direct argument against market timing. Said plainly, if you’re following SMI’s strategies, you don’t need it.
Settling this issue is important for investors right now. The current bull market is approaching its seventh birthday and, by many valuation measures, stocks look overpriced. Having already suffered twice in the past 16 years through the now-familiar pattern of Fed-induced bull market followed by a bruising bear market, many are loathe to repeat the “bruising” part a third time.
Before delving into the specifics of why SMI investors don’t need to try to time the market, it’s worth quickly establishing some credibility on this topic. We don’t come to the topic of market timing from a purely theoretical basis, as many do. Many readers may not realize that for the dozen years prior to starting SMI in 1990, our founder Austin Pryor was a successful money manager using — yep — market timing as his primary strategy! Not surprisingly, then, we are not in the camp that says market timing can’t be done. We know it can.
That said, Austin’s dozen years of experience using market timing to professionally manage client accounts has provided a wealth of insight into the challenges and pitfalls of the approach. Austin’s experience matches that of Paul Merriman, another professional market timer who worked with clients using that approach for many decades. Surely he’d recommend it to people if he actually managed money that way for so long, right? Consider his comments in an article he wrote for MarketWatch in 2013:
“I don’t think more than perhaps one in 100 investors will be successful using timing.... Nearly half a century of working with investors has taught me this: Many people who try buy and hold succeed, while most of those who try timing (particularly those who do it themselves) fail.”
The late stages of a bull market, which presumably we are in right now, is when the appeal of market timing is the greatest. Hindsight being what it is, it’s difficult for investors to look at Chart 1 below, showing the S&P 500’s path over the past 15 years, and not believe that they could have avoided a good deal of the pain by selling when the market was high and buying back in after it had fallen.
This idea is powerful even for those who were investors during those earlier bear markets and had the opportunity to do just that! Of course, they didn’t because market timing is infinitely more difficult in real-time when you can’t see what’s coming next on the chart.
Moving from indexes to SMI Strategies
I’m attempting to persuade you to avoid market timing based on a different appeal than what you’ve probably heard before. Rather than “It can’t be done” or “It’s too hard for you,” we’re going to show that trying to time the market simply isn’t worth the effort and risk if you’re already utilizing SMI’s active investing strategies. As you’ll see in this article, the performance of the SMI strategies, properly combined, has been such that any marginal benefit gained from timing isn’t worth the significant emotional toll, not to mention the high probability that a person will make some mistakes identifying appropriate exit and re-entry points.
All of the charts that follow show the growth of a $1,000 investment in a particular strategy or index. It's a handy way to compare the performance of a given strategy relative to the market or another strategy. It’s important to recognize that most SMI readers don’t invest in the market indexes (unless they’re using our Just-the-Basics strategy, which uses a combination of market index funds). Rather, they’re investing in specific strategies that often follow very different paths than the market itself.
Chart 2 below at right illustrates this by focusing on the performance of SMI’s Upgrading strategy during the late 1990s and early 2000s, including the bear market of 2000-2002, with the S&P 500 also shown for reference. We’ve zoomed in on this period so you can see more clearly what was going on during these years.
Getting out…and back in
While there are any number of market-timing strategies in existence, the most common one individuals use to get out of the market goes something like this: “The market has gone up a lot and seems high, it recently dropped quite a bit and the news is scary, so I think I’d better move some of my investments to cash.” Not especially scientific, and not likely to produce good results either.
Unfortunately, getting out is only half the battle. Anyone who has actually sold stocks and moved into cash knows the agony of trying to decide when to get back in. This decision too often boils down to waiting way too long because of the trauma the investor has just been through watching the market drop so far, plus the fact that the news/mood is still universally gloomy in the early stages of a new bull market. This means amateur market timers almost always are getting back into the market after stocks have rebounded substantially off their lows.
Taking an optimistic view of those two conditions leads to exit and re-entry points similar to those shown on Chart 2. Consider the backdrop. Stocks had been rising for years, so much so that Fed President Alan Greenspan had warned the market was “irrationally exuberant” in December 1996 (before stocks rose another 33% in 1997 and 22% more in early 1998). In the summer of 1998, however, the stock market fell more than 18% in about six weeks. Investors’ gains were disintegrating daily with no optimistic news to be found. If a person wasn’t following a disciplined, mechanical system but wanted to “take some chips off the table,” this would have been the time to exit (see dots on left).
As for getting back into stocks after the bear market, consider that the market had fallen for roughly two-and-a-half years through October 2002, erasing almost half of the value of the stock market. It then proceeded to rally, only to fall again, nearly reaching the October lows again by March 2003. We’ve charitably assumed that after just six months of gains (dots on right), an investor would have been willing to jump back in. (Based on our own experience interacting with SMI members, we know that many investors took far longer to move money back into stocks.)
On the S&P 500 chart, such timing maneuvers — while ultimately counterproductive from a pure profit standpoint (because the investor is buying in at about a 12% higher price than where he or she sold) — could almost be understood, given they would have spared an investor the emotional pain of the bear market.
In contrast, for an SMI Upgrader such a timing decision would have been a disaster! True, they would have avoided the emotional pain of temporarily losing roughly 25% of their balance during the bear market. But the cost of getting out too early and getting back in too late would have been huge — they would have sacrificed gains of roughly 75%!
The bear killer — Dynamic Asset Allocation (DAA)
In fairness, Upgrading didn’t hold up as well during the 2008 bear market. That second bear came on so swiftly, and ripped through all corners of the stock market so thoroughly, that there was nowhere for a fully-invested equity strategy like Upgrading to hide.
Thankfully, Upgrading isn’t the only tool in the SMI investor’s toolbox. In fact, the tool best suited to deal with the specific dangers a bear market presents is our DAA strategy, which rotates among six different asset classes, investing in the top-performing three at any given point in time. This strategy aims to “win by not losing” — an indication that it should be particularly adept at handling bear markets.
Sure enough, a quick glance at the DAA performance in Chart 3 of this second bear-market period reveals that…wait, what happened to the bear market? DAA never had one! There was a small decline through the middle of 2008, but nothing approaching the 20% decline typically required to define a bear market. This occurred during a period when the stock market lost more than half of its value! As Chart 8 below shows, DAA’s performance during the earlier 2000-2002 was just as impressive.
DAA’s secret: market timing is baked in
Time for true confessions: while we’ve purposely never used the term “market timing” when discussing DAA due to the baggage frequently associated with the term, there is a strong timing element baked into the strategy. Consider the two main difficulties a market timer faces: (1) the actual decisions of when to exit/re-enter the asset class being followed, and (2) the emotional toll market timing extracts from the investor. DAA obscures the fact that there’s timing involved by allowing the investor to think and act like a buy-and-hold investor, while providing what historically have been reliable signals for exiting and re-entering the various asset classes.
The primary reason DAA has been so successful at avoiding steep losses during bear markets is it has the ability to completely exit stocks during those periods. While we’d prefer DAA investors not even think of it as “timing,” there’s clearly an element of that involved. Yet it’s done in such a way that most of the additional emotional burden associated with market timing is avoided. Following regular monthly signals between six asset classes seems like so much less of a “do or die” decision than the traditional “sell stocks and move to cash” market timing call that most investors are actually able to follow through consistently.
SMI’s “Bear Alert” and “All-Clear” signals
The primary goal of this article has been to make the case that if SMI members are using an appropriate combination of SMI’s strategies, there’s little value to be gained trying to add any market timing maneuvers of their own. In fact, to put a fine point on it, we think most investors are more likely to hurt their long-term returns than help them by trying to time the market in any additional way.
That said, we recognize that there are readers who have at least a portion of their nest egg locked in a 401(k) or other type of plan that offers very little flexibility and no way to reasonably try to follow the signals from DAA or any of SMI’s other strategies. For these investors, SMI continues to track and report on our Bear Alert and All-Clear signals.
Our September 2015 cover article focused on the Bear Alert in detail, so I won’t cover that ground again except to briefly explain these two timing indicators. The Bear Alert signal was something SMI came up with a decade or so before DAA, which simply recognized that broad market declines of 15% typically have gone on to become full bear markets, causing significantly greater losses. As market timing indicators go, it’s a pretty blunt instrument. But while it will have occasional false alarms (such as in 2010 and 2011, when losses of 15% occurred that didn’t follow through into full-fledged bear markets), it’s been reasonably helpful in getting out of harm’s way during big bear markets.
The All-Clear signal is another old SMI creation that offers an attempt to provide a conservative estimate of when someone who has exited the stock market can safely re-enter. This is not an attempt to provide an optimal re-entry point — if that was our goal, we’d likely try to get back in sooner. Rather, this was designed for the person who is out of the market and scared. It’s rarely been “wrong” in terms of getting back in too soon, but it has left a lot of profit on the table compared with already being invested in the early stages of a new bull market.
The actual exit and re-entry points provided by the Bear Alert and All-Clear signals are shown above for each of the two major bear markets in recent history — Chart 4 above for the 2000-2002 aftermath of the dot.com collapse and Chart 5 for the selloff caused by the financial crisis of 2008-2009. We show the S&P 500 for reference, followed by the performance of SMI’s Upgrading and DAA strategies, and finally how a portfolio diversified using the 50-40-10 approach (50% DAA, 40% Upgrading, 10% Sector Rotation) would have fared. The Bear Alert and All-Clear signals are provided so you can gauge their effectiveness for yourself. Again, each chart assumes an initial investment of $1,000 in the given approach.
Charts 4 and 5 make it clear that using the Bear Alert and All-Clear signals would have significantly improved performance relative to the S&P 500 index alone, thus providing a benefit to those following SMI’s Just-the-Basics indexing strategy. Their performance when applied to SMI’s active strategies, however, is more hit and miss.
For example, they hurt DAA and 50-40-10 in 2001-2002, but helped Upgrading in 2008. Keep in mind that using the Bear Alert and All-Clear also comes with a hidden cost — false signals are occasionally produced. In both 2010 and 2011, false signals would have sent investors to the sidelines just as strong market recoveries were about to occur. Given the inconsistent benefits provided to those investors using SMI’s active strategies, it’s our opinion they’re generally not worth the hassle.
To be clear, for most SMI readers, we think a simple combination of SMI strategies such as the 50-40-10 portfolio advocated in several past articles (See the May 2014 cover article and this May 2015 article) is sufficient that no additional timing effort is required. But if these strategies are impossible to implement and you want some sort of mechanical guidance to reduce the risk of large bear-market losses, the Bear Alert and All-Clear may be of some assistance.
Clearly, there are huge differences between the stock market’s overall performance (as measured by the S&P 500) and the results of the SMI strategies. In each case, the evidence indicates that trying to time the market would have been unlikely to produce much (if any) benefit, especially when the difficulties of identifying profitable exit/re-entry points are considered.
The full 18-year history for each of the four approaches is charted below so you can see the cumulative impact of simply staying the course in the various strategies. Hopefully, this evidence is sufficient to relieve any readers of the pressure they may have been feeling about making pre-emptive timing decisions regarding their portfolio. SMI already provides all the tools you need so you don’t have to carry that additional burden.