Guilty as Charged

It is something of a received wisdom in both mainstream financial media and PF blogosphere that “market timing doesn’t work”. The refrain has been used to argue against everything from DCA of a lump sum to rebalancing after a market drop. In chat rooms, “Well, that’s market timing!” is often uttered with an air of discussion-ending-finality – at least in the mind of the utterer – not unlike playground bickering among school-aged children. OK, jesting aside I do agree with the basic premise that most investors shouldn’t try to “time the market” meaning getting in an out based on some hunch or technical indicator or some guru’s prognostications. But how universal is that statement? What are the underpinning assumptions? These are the questions we must ask if we do not blindly accept everything we’re told.

I want to start by defining the term “market timing” in the broadest sense:

To market time is to stay invested when the price trend is up and to be out or short when the price trend is down.

The statement is about the desired end goal and does not in any way explain how or whether market timing is feasible. The polar opposite approach, that of the passive index fund investor, is

Stay invested in the market at all times, according to an appropriate asset allocation.

So how will these two approaches fare? The key insight is to realize the importance of the relative time scales of 1) the intended holding period (time-in-market), and 2) the characteristic time of market movements. Below is my (very poor) sketch of a long wave with period T1, a short wave with period T2, and holding period H, shaded in red.

time_scales_20160908

When T1 > H > T2, it follows that the shorter ups-and-downs corresponding to T2 are simply averaged out, while the longer trend corresponding to T1 will fully exert itself, so much as to dominate the performance during holding period H. A more pertinent range of T1 is probably up to 4 times H. A much longer T1 will make the larger wave appear as a flat baseline. At any rate, it should be clear that the investor can safely ignore shorter fluctuations especially if he is not equipped to take advantage of them, but conversely must pay close attention to longer trends and position himself appropriately (i.e. market time) lest getting caught in a prolonged downtrend.

The discussion has been kept as general as possible. The “market” hasn’t been defined. It can be any equities, bonds, or commodities, market indices or individual securities. The use of sinusoidal waveforms is not especially restrictive since any price series can be Fourier transformed. The analysis is ex post however, by virtue of completed waveforms being drawn. The latter point brings in the topic of forecast reliability which will be addressed in the future.

Holding Period

The holding period is the average length of time the investor expects to be in the market, usually determined by life events. I feel strongly that many investors overestimate his holding period. Personal finance education material will typically include a graph on compound growth over 30 years or so. In reality, no very few people invest a lump sum untouched for 30 years. The more likely scenario is making periodic contributions throughout one’s accumulation stage. If contributions are equal dollar amounts then right away the (contributed) dollar weighted average holding period is cut in half to 15 years. The far more likely scenario is the contribution grows with earning power, so that the average holding period could easily be not much more than 10 years.

The portfolio value weighted average would be much shorter than the the working career since the highest value occurs just before retirement. The whole process of saving for retirement is aptly described by Michael Kitces as Save For Decades, Then Quickly Double Your Money And Retire. Indeed the sequence of return risk applies to the final years of accumulation as well as early years of retirement but the awareness for the latter is much greater. A more in-depth article from Kitces contains this gem:

kites_retirement_date_risk

This topic is pertinent to me as I plan for my own possible retirement in 10-12 years. The withdrawal stage is a completely different animal from accumulation where volatility is exacerbated – a mathematical fact. Although one can identify a “dollar” that stayed in the same asset across the retirement threshold, that “dollar” would be subject to different risk-tolerance and likely different allocation rules. The psychological difference may be even greater. I speak from personal experience as I once left my well-paying job to pursue my own business ideas and also became a STHD for three years. I was to contribute my share of living expenses from savings and investment income during this time. My timing was awful as I quit my job in mid 2007. When the Great Recession rolled around, whatever investment plans I had didn’t survive losing the equivalent of 3-months’ expenses in one day. For me retirement is such a clear demarcation that I consider 10-12 years as my maximum holding period. By the earlier reasoning, as the holding period shortens more market oscillations will need to be carefully negotiated because there is less time to recover.

Shorter Duration Fluctuations

I have a very small allocation (several % of my active portfolio) for swing trades lasting days/weeks/several months. I’m also a premium seller for options 3-6 weeks out. But for the majority of my accounts, I consider the following events “noise”:

  • Intra-day movements
  • Movements related to Fed/central bank meetings, GDP, ISM, employment numbers
  • Quarterly earnings
  • Relative sector movements – example will be sectors like utilities or biotech falling in/out of favor. This is actually a borderline case as far as my ability to take advantage of the ups and downs. Relative movements can last anywhere from six months to a year or more that in theory can be recognized through technical analysis. However, I don’t have a dedicated space for this kind of trading. It’s natural for me to “buy low” in my DGI portfolio, e.g., industrials, some staples and financials of late, but since they are intended as long term holds, I’m not looking to “sell high” at the end of the same cycle.

Longer Duration Trends and Cycles

Now for that I cannot ignore:

Mass Extinction Events
– Ha, just trying to see if you are paying attention! The point is not whether there is a 60 or 26 million year cycle to extinction events (in either case we’re safely outside of the danger zone), but whether there is any cycle that will upend the widely held belief that should just sock away money in a TSM index fund and forget about it.
Long term global growth
– No I’m not being facetious. Long term growth cannot be taken for granted; one only has to turn on the TV or read the newspaper to see pain and suffering, gloom and doom everywhere. The thing that gives me hope for humanity’s future is that we’re still expanding our knowledge and using it to make our lives better. In fact knowledge is being expanded and disseminated faster than ever before. As long as that trend is still in place, I’m willing to overlook how destructive some people can be.
Armstrong cycles
– I read Martin Armstrong everyday. You will have to distill what he says into actionable advice but he is the real thing.
Long term market forecast
– There is a multi-year equity price forecast model that I have verified and assimilated. It’ll inform my investment/trading plan for the next 3-5 years. With a model like that it’s important to note the “tracking error”, i.e., what it advises differently than simply stay invested. For now there is none and the model is not at all concerned with the equity valuations (ie. CAPE) that many are worried about, notwithstanding some churning into 1Q’17.
Recession watch
– The next recession/bear market will likely be severe and take a decade or more to recover from in real terms. Even though none is visible on the horizon one will almost certainly hit within 10-12 years. The best case scenario will be to grow my portfolio enough before that happens so that I can dial back on risk exposure. That’s something I’ll monitor.
Macro cycles
– There are three long-term trends that I can point to concrete actions I’ve taken or will take in response:

  • Long term interest rates might finally tick up. I don’t profess to know when or by what catalyst, but the majority of my fixed income allocation in my passive portfolio in stable value funds that has little principal risk.
  • The rise of the East relative to the West. So far I haven’t done enough analysis on individual EM stocks. For now all I have is an overweight in EM in the passive portfolio.
  • I have a healthy allocation (~15% overall) to precious metals. The long term expected return of PM is only to keep up with inflation but it can act as a hedge against government folly, of which there is abundant supply. I have been in PMs since 2002 and held through the correction from 2011, though the tide has turned since early this year. My target price for gold is $3500-5000/oz for this cycle, after which I expect to keep only a few coins.

A passive indexer will no doubt look at what I’ve written and call me a “market timer”. To which I’ll proudly reply, “Guilty, as charged!” It’s an admission with considerable thought and qualifications: I’ll apply my timing methods to those multi-year to decade long trends using the models/indicators I have vetted. The goal is both risk control and return enhancement. The process will be documented in this blog – only time can tell how successful I’ll be.

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