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