Market timing: when do we get out

One of my favorite B-school professors (this prof taught Money & Banking and Bond Management, and did a great job at both) once said that "if it's good in theory and not in practice, well then it's not really good in theory, either", and after 12 years of managing money, and 20 years in the investment business, I have to agree with him.

In academic theory, at least in most textbooks, a student is taught not to "market-time" i.e. to move in and out of cash and stocks in order to maximize gains and minimize losses. In fact many studies have been done that have shown that if an investor misses, or is out of the market and in cash, just two of the best days of a rally off a major market bottom, then they may see their holding-period return cut almost in half.

A case can be made for both market-timing and not market-timing: however if there is one lesson we learned in the 2000 - 2003 bear market, it is that client's like "absolute return" in a down market, meaning they don't want declines in the stock or equity portions of their portfolios (which makes sense) but client's like relative returns in up markets, meaning that clients not only want to see gains, but better than benchmark gains, in good markets (and again, that makes sense.)

In other words, in order to be an effective money manager, you have to time the market in some form or fashion. You have to take gains for clients at some point, and cut losses at some point.

Since we are entering the 4th year of this bull market in equities since the March, 2003, market bottom, I needed to update clients on our thinking about market-timing and let clients know that we are using market-timing tools so as to not repeat the mistakes of the early 2000's:

1.) The first "market-timing" barometer we are using is the Thomson Financial Market Risk Premium (TMRP) calculation, updated every week, which is a combination or derivation of the Fed model, and quantifies in one number, whether stocks are "rich" or "cheap" relative to historical norms.

On Friday, May 25th, 2007, the TMRP showed that the S&P 500 has a risk premium of 8.6% (this is not technically an equity risk premium, but it is close, and I'd show clients the calculation, but I think you'd get lost in some of the math and the logic, and you'd lose the essence of the calculation ). The TMRP hit a high of 9.8% in October, 2005, and a low of 4% in March of 2000, thus as you can tell from Friday's reading, the TMRP "range" is much closer to the historical high showing that the S&P 500 is still relatively, attractively valued, versus the low in March of 2000 when the TMRP showed the S&P 500 historically overvalued. The TMRP is not a "precision" timing model, it gives a signal over time based on a number of factors, and it is more like an hourglass than an alarm bell.

2.) The second marketting tool we are using is Bob Brinker's monthly Markettimer newsletter. Bob Brinker is rated one of the top marketimers in the last 5 and 10 year time periods per the Hulbert Financial newsletter tracking service. When Bob says get out, we'll get out (with a caveat to be discussed below) and we'll do it quickly, particularly if the Markettimer market call coincides with the TMRP signal, and without regard for capital gains (unless a client specifically asks us not to sell). Bob Brinker is currently bullish on the state of this cyclical bull market, primarily due to the high pessimism seen in the 60-day put-call ratio, and the relatively low P/E ratio for the S&P 500 relative to previous market tops. The put-call ratio is currently skewed to a high number of puts versus calls as investors look for downside protection.

Finally, just because the market gives a sell-signal doesn't mean that we need to get out of equity or sectors, or individual stocks entirely. In 2000, housing and homebuilding sectors, and gold and precious metals started to break out of long-term technical consolidations, thus it could warrant some equity exposure in long-out-of-favor groups, should the market start to roll over.

My guess is that if and when this bull market peters out, we will likely first sell the current leadership groups like energy, like commodities and utilities and telecom (since these sectors will have the most downside risk) and we will likely see the old growth babies of the 1990's, like GE, like AIG, and large-cap tech and financials, possibly become the "safe-havens" of the next bear market.

Right now though, it is too early too tell what the next bear market might look like, and we are staying invested in a combination of sector ETF's and individual stocks. Higher interest rates, particularly the 10-year Treasury yield, will push that TMRP lower, thus I do believe that higher rates and slower earnings are the biggest threat to this current bull market.

If clients want to see the actual TMRP calculation, let me know.

To conclude, we are using the "belt and suspenders" methodology in terms of market-timing.
One sell signal will be a yellow light, and we'll alert clients accordingly and two sell signals - one from each service - will result in a major shift in our holdings for clients.


position in S&P 500 index funds, SPY, ETF's, GE, AIG

Avoiding China, Russell 2000, and REIT's

Michael Santoli's editorial column this weekend (within Barron's) was right on target in my opinion, as China has now become to the decade of the 2000's, what Japan was to the 1980's, i.e. the hot market, the economic model to be worshipped and the "it" economy, kind of the Paris Hilton of global economies, and you really can understand why when the latest "reported" GDP growth for q1 '07 for China was north of 10%.

Michael Santoli talked about the P/E multiple of the Shanghai Stock Exchange being "50(x) earnings" which one could deem as an expensive valuation, but my thought when I read that was "what constitutes earnings" ? Throughout my career when I've heard analysts or portfolio managers or whoever talk about the valuation of a foreign stock or foreign market, you don't often hear them talk about the quality of those earnings.

Because of the global economy, the world seems to be moving towards a uniform set of accounting standards, which would leave companies from different countries with a more uniform set of financial statements for analysis. In fact if we dissected China's corporate earnings, we could find the Shanghai trading at 100(x) earnings or 20(x). (I'll let you guess which valuation is more likely.) Most people, if you listen solely to the news, probbaly have forgotten that China is still a Communist country, and although unlikely, could still wake up one day and see that the government has "appropriated or nationalized" the country's asset base. (The risk is small, but it is there, or maybe some derivation thereof...)

For present clients, we are staying away from international in general, and China in particular for the time being, given the enormous popularity of investing "internationally" and given that if China should crack, there is a high likelihood of a contagion effect throughout Southeast Asia. According to one source, over 90% of all mutual fund inflows in 2006 (can't remember if it was an Investor's Business Daily article, or an IBD article referencing a Citigroup research piece where we read the statistic) went into "international" funds, and we'd love to own this asset class, just not now.

Regarding the Russell 2000, small-caps have outperformed large-caps, particularly the S&P 500 for 6 - 7 years running, and the valuation of the Russell 2000 is almost twice that of the S&P 500, interms of the P/E ratio.

Tony Dwyer, the equity strategist at FTN Midwest and a frequent CNBC contributor, e-mailed me some data on Friday showing that the Russell 2000's P/E is 28(x) trailing earnings for 15% y/y growth, or almost 2(x) PEG. In and of themseleves these statistics aren't bad, but when compared to the S&P 500's 16(x) forward eps for what has been quarterly growth of 10% - 15% year-over-year year earnings since the March, 2003 bottom, you can quickly see that the S&P 500 is more attractively valued than the R2K, and the S&P 100 (or the top 100 stocks in the S&P 500) is even cheaper than the entire index. (In April, '07, the S&P 500 rose 4.43% while the Russell 2000 increased just +1.80%; I don't know or want to say that that is a trend, just the amount of underpeformance was surprising. You would think - at some point - that large-caps would "mean-revert" and start to outperform small-caps.)

Finally, although we have recently bought the XHB (homebuilder's ETF) for some client accounts, we are staying away from REIT's in their entirety, although commercial property REIT's still seem to have a decent valuation given the strength of corporate cash flow.

We'd love to own all these groups once again, particularly international via Oak Mark's David Herro's International Fund, David being one of the best portfolio managers in the international asset class today, but I would prefer to wait until we get an inevitable currency disruption or exogenous event to take hot money out of these groups.

To conclude, we sold our Russell 2000 too early in 2004, 2005, and we sold our REIT's too early as well, and we continue to think that the S&P 500 remains relatively cheap, and unloved relative to the rest of the world.

long S&P 500 index funds, SPY