Tag Archives: stocks

In Defense Of Market Timing (Sort Of)

Summary Typical studies that demonstrate why market timing is a bad idea have a fatal flaw: They’re not so much “market timing analyses” as “perfect market mis-timing analyses.” The options market gives us a feel for how to recast the problem. Some practical thoughts on actual pros/cons for market timing. We’ve all seen the studies, and the conclusions are the same: it’s not about tim ing the market, it’s about time in the market (tell that to the Japanese). I’d like to discuss why there are fatal flaws in the classic study put forth to investors, a study which seemingly demonstrates why market timing is a bad idea. But before going further, I would like to point out that I am attacking the typical anecdotal study, not the overall advice. This piece is not an endorsement on market timing. First, I present the typical kind of reasoning that is set forth for why one should never attempt market timing. This is one particular case, but there have been many variations presented throughout the years, and most investors have been exposed to one or more of them. From Horan Capital Investors : Making ill-conceived market moves can reduce the growth of one’s investments substantially. The below chart graphs the growth of the S&P 500 Index from 1990 through June 30, 2015. The blue line displays the growth of $10,000 that remains fully invested in the S&P 500 Index over the entire time period. The yellow line shows the same growth, but excludes the top 10 return days over the 25-year period (6,300 trading days.) By missing the top 10 return days over the 25-year period, the end period value grows to only half the value of the blue line that represents remaining fully invested. (click to enlarge) Chart source: Horan Capital. Wow! Pretty compelling. Missing out on just the top 10 days out of 6300 cuts my total return in half! Market timing must be a terrible idea, right? There are many very legitimate reasons to argue against market timing, and I’ll discuss some of them in the conclusion. But first, let’s dig deeper to see if there’s anything interesting taking place during those 10 “best” days. Indeed, the cumulative return for participating in those 10 best days amounts to 100% – but look at the dates! The dates these earth-shattering returns occurred teach us some valuable lessons. Two of the dates were March 10 and March 29, 2009 – the furious beginning to the new bull market. It would indeed be tough on an investor to miss those dates, as the train was leaving the station. Bull markets often begin with strings of giant gains, and as such there probably should be some plan to get back in if you dumped your stocks and have plans to rejoin. On the other hand, eight of the dates were merely bursts with plenty of room left for the market to fall. If you got out – and stayed out – the day before any one of those great days, for 3+ months, you’d have been very happy that you had missed both the huge rally as well as the ensuing freefall. In fact, if you got out just before the 9/30/08 5.25% gain, you could have stayed out for the next three years and not lost out on a penny of gains, even though 2.5 of those three years were part of the new bull. Big up-days happen when there is outsized volatility. The trouble I have with studies like the Horan study is that they effectively show you what would have happened if you were an absolutely perfect market mis-timer. Now granted, haven’t we all felt like we were perfect mis-timers? I sure have, and I’ll bet you have too. But this study – and multitudes like it – actually quantify for you how costly being a perfect market mis-timer would be: in this case a doubling of your capital. To further understand why the Horan study asks the wrong question, let’s invert it: How much more money would you have if you only missed the ten worst days in the market? Here they are: Missing the worst ten days in the last 25 years for the S&P would have more than doubled your money! Furthermore, nine of those ten times (1997 excluded), you could have gotten out after the bad day, and still have been happy for several weeks or months to come – even though you would have missed some monster rallies along the way (consider how closely the best and worst days are clustered). Taking aside taxes, transactions costs, and the like, if you could side-step the best ten and worst ten days, you would have been better off to have missed both. Participating in all twenty of those spectacular days cost you 7% cumulative of your ending balance. This is likely not just a fluke, as the stock market has long been known to exhibit negative skew, where the log-magnitude of big down-days are larger than for big up-days. The options market lends insight on the matter. (click to enlarge) Look at the VIX prints for the close of each of the prior days. If we plug those VIX levels in for a one-day option price calculator, struck at the close the prior day, we obtain the call price column. I’ll add that there’s a very good chance that the VIX would have been in backwardation during many or all of these dates, and so the actual call premium would likely have been higher still. If you had hedged your SPX holdings by selling a one-day, ATM call against your position, you would have reduced your SPX winnings relative to not hedging at all. But you would have earned 16% in total call premium, and as such the missed opportunity would have netted to 72% rather than 100%. This highlights two big ideas that are each worthy of note. First, if you sold a one-day call just before one of these hall-of-fame days, then you had some terrible luck: you sold a lot of gamma one day before a giant move. But notice that the options market was at least pricing in very large swings in all ten of these cases. Your missed opportunity, while still large, was dampened considerably. Put differently, your missed opportunity was unfortunate, but predictable. Second, I think framing the study in terms of the ultimate unlucky options trader demonstrates just how unlikely being a perfect market mis-timer really is. Think about it: what are the odds that you would sell one-day ATM calls, ten times in your entire stock-holding career, with each instance being met with one the ten best days in the last 25 years? ZERO! But that’s the same likelihood that you would just miss only the ten best days, and nothing else (forget the options). What if you sold a one-day, ATM option every day, including on some of those worst days? Perhaps the 72% you had missed out on would largely (or more-than-fully) be recouped. Conclusion Studies of the Horan variety above are simply not serious studies of market timing. It doesn’t mean that they don’t offer insight, but they give it in a way that clouds a greater reality. Being a perfect market timer would be amazing — but that alone is not a reason to attempt it. Likewise, being a perfect market mis-timer would be horrific, and that alone is no reason why you should avoid it. There are good reasons for avoiding market timing, but they have nothing to do with the study (quite the contrary; I’d argue that the study recommends running to high ground early and waiting for the dust to settle). Here they are: Transactions costs: lots of portfolio churn needs to be carefully considered. You need to think about what the broker, and what the market maker, is earning off your trade. It does not mean you shouldn’t trade, but it is undoubtedly a con rather than a pro. Taxes: tax losses are treated asymmetrically from tax gains, which skews your after-tax risk profile. That is a perfectly legitimate reason to avoid “market timing”. Psychology: This is by far the biggest reason investors shouldn’t time the market. Investors and traders are not the same animal. They have different skill sets, different perspectives, different goals. Traders time the market almost by definition. Most fail, and a few do quite well. Investors should not be market timers precisely because being a market timer has a lot in common with being a trader, and very few investors are good traders. Imagine morphing from being an investor (something you might be good at) into being a trader (something you are probably bad at) at the worst conceivable time. Look at those dates for the best 10/worst 10 days – what a nightmare! Is that the kind of environment where you want to consider shifting away from what you do know toward what you do not know? This is the real reason that investors should not attempt to time the market. Finally, when SHOULD an investor open or close a position in a meaningful way? I mean, couldn’t we describe any buy or sell order market timing of sorts? Is it part of your overall strategy? Do you have a lot of cash – waiting for weeks, months or years to get in, and then when the market falls, you get out? That’s undisciplined selling: that’s an investor acting like a trader. Note from the discussion above that there’s an outstanding chance that your “trade” will go well and you’ll be happy you panicked, at least for awhile. If that’s you, you should be asking: “When do I plan to get back in? Proverbially or literally speaking, what put option will I sell TODAY to lock me into getting back in should the market actually fall that low and I lose my nerve?” On the other hand, maybe you are selling because this is part of your discipline. “Ride my winners, cut my losers.”; “I don’t hang around in high-vol environments hoping for a recovery (they don’t all end with a V-bottom!)”. This is a legitimate reason to “panic” and sell: it’s part of your strategy. While you might be unhappy if the market rebounds, you did the right thing, even if you got the wrong result. Maybe you should tweak your strategy, ex post. Maybe the market is showing you that your strategy has some meaningful flaws that you never considered or took seriously. Reducing your position size – even to zero – could be prudent. It’s one thing when markets are going from bad to worse and it’s part of your discipline. It’s quite another when you never foresaw the eventuality that you’re in, and volatility is heavy on the market. You’ll know this to be the case when you are asking yourself – as an investor – serious questions about your own long-term investing style. You’re not considering “a trade”, you’re considering a change. Best of luck, I hope the bulls need it!

Facebook Heads 4 Tech Leaders Losing Key Support Area

In a market correction, even leading stocks usually succumb. Facebook (FB), Google (GOOGL), Palo Alto Networks (PANW) and Salesforce (CRM) are all tech leaders, but they stocks fallen below a critical support area. All four stocks are part of IBD’s Young Guns Screen of the Day — top-rated companies that have come public in the last 15 years. Younger companies are more likely to be big stock winners. Facebook (CR 98), Google (CR 96), Palo Alto

Stocks Are Cheaper Than Bonds, And Other Falsehoods

Summary Currently, the crowd continues to advance the notion that stocks are the only investment to be considered, despite the overvalued condition in risk assets. The notion that bonds are overvalued and underperform stocks, and that cash is earning 0% is also advanced by the crowd. In reality, cash and bonds offer investors tremendous value in a world of declining economic growth. This is especially true given that the economic risks are rising. Stock Market Valuations within the Context of Global Economic Instability: Implications for Portfolio Construction Stocks are cheaper than bonds, or so we are told by the crowd which was out in full force again for the September FOMC meeting, calling for a rise in interest rates, despite the fact that we have not met any of the conditions for such a rise in rates. One of the major reasons investors, and more specifically savers, have for why the Fed should raise interest rates is the notion that cash is currently earning close to 0% on savings, and money market balances. However, when viewed within the context of the global economic environment, and when we take into account the impact of a rising dollar on purchasing power, cash is providing investors with a very nice return. In a previous piece , I explored the reasons behind holding cash. As risk asset prices have risen to lofty levels, investors are far better, in my opinion, holding a majority of their assets in Zero Coupon U.S. Treasury Bonds and cash. The Global Economy and the Rise of Deflationary Forces Why would I pursue a strategy of largely abandoning risk assets for fixed income and cash? For several reasons: 1. CAPE valuation The first reason is valuations. Valuations in the US are trading at levels that are more than 53% above its arithmetic mean and 65% above its geometric mean, as seen in the charts below. As the earnings season begins, the street is expecting a 4.6% decline in S&P earnings. I would contend that this is far more modest than what the actual numbers will turn out to be. The strong dollar continues to be a headwind, as is the decline in overall demand. This, combined with the complete decimation of the commodities complex , declining fundamentals in the global economy, and a FED that keeps the markets uncertain will likely lead to a severe drawdown in risk assets. In such an environment, cash and Zero Coupon U.S. Treasury Bonds are excellent investments. (click to enlarge) (click to enlarge) 2. The Real Yield on Cash The U.S. dollar has been rallying in the face of rising deflationary forces globally. Over the past three years, the U.S. dollar has soared 14.6%. I expect further economic weakness, and growing challenges overseas, combined with extraordinary monetary policy from the BOJ and the ECB will drive the US dollar higher relative to the yen and euro as well as other foreign currencies. As the value of the dollar rises, so does the buying power of Americans cash balances, making the real yield on cash much higher than the current minimal rate of interest. 3. Deflationary Forces and Tepid Economic Growth The challenges overseas are well documented. Japan remains in an economic malaise, even as Abenomics attempts to bring it out of the doldrums. The eurozone remains entrenched in an extremely slow-growing economic environment on the verge of recession, with deflationary forces rising. Canada is currently in recession, and in the United States, many try to make the case that the economy is doing just fine. But the reality is that the economy is a patient in need of ICU classification, as the charts below will indicate. The labor force participation rate is at its lowest level since 1978. (click to enlarge) To those who believe this is largely caused by the retirement of the Baby Boomer generation, the next chart will be particularly useful in dispelling this idea. (click to enlarge) Falling industrial production and ISM Manufacturing (below) are not indicative of an economy running on all cylinders. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) The data point that I find most concerning is the complete collapse in velocity to the lowest levels in more than 50 years. Despite the Fed’s massive QE program, velocity has continued to decline. (click to enlarge) Implications for Portfolio Construction The world is currently on the verge of a recession . Conventional investment planning has largely failed to protect client assets multiple times in the 21st century, largely due to its reliance on risk assets for the majority of client capital. I believe in a more conservative approach that protects investor capital through a complete investment cycle. On February 18, 2013, Dr. John Hussman wrote an excellent commentary entitled ” The Sirens Song of the Unfinished Half-Cycle ,” in which he explains the overvaluation of the market and the likely drawdown that will result in the completion of this market cycle. (click to enlarge) Since Dr. Hussman wrote this commentary, valuations have only extended further, making the current conditions all the more unstable. These are not conditions in which I would, in good conscience, be overweight risk assets. Especially that which is needed for retirement, regardless of age. I believe capital preservation is the key objective, and I am willing to miss excess gains on the upside when the market gets expensive, rather than be exposed to a severe drawdown due to speculation in an overvalued market. As we seek to preserve capital, cash and cash equivalents (Treasuries) appear to be the best investment vehicles in a world of slow economic growth with rising deflationary and recessionary risks and overvaluations on risk assets that make future returns minimal. While the equity risk premium has already been debunked , the future will likely give us a further case study. One thing I have learned in my decades of investment experience is that the habits of successful investing are often contrary to common human behavior. This is why we seek to ignore the crowd and the noise that accompanies them. I have been writing about our extensive exposure to U.S Treasury bonds for some time. Currently, Treasury bonds are one of the most vilified assets around, and yet, from 2008-2015, long-term Zero Coupon U.S. Treasury bonds have returned 107.91%, while the S&P 500 has returned 64.89%. During this entire period of time, the crowd was vilifying Treasury bonds and telling investors to favor equities. In this case, following the crowd would have cost you a 43.02% gain. Conclusion While many investors and savers may be frustrated by the lack of interest they are earning on their cash balances, the buying power of their cash continues to rise as the value of the US dollar increases. In this environment, cash and cash equivalents are king, and as major headwinds from global growth concerns and U.S. dollar strength, among other factors, begin to reduce the earnings power of U.S. companies, the market will correct in tandem. Additionally, we face continued market uncertainty surrounding monetary policy and the possibility of a government shutdown later this year, which could cause additional stress on the market. I continue to feel comfortable with the majority of our assets in cash and long-term Zero Coupon U.S. Treasury securities as well as select short positions, with an underweight in equities, favoring cheaper-priced foreign equities over those of the expensive U.S. market.