I hear this question fairly often, and almost always after the market drops dramatically in just one or a few days. The short answer is: "It depends." I’ll give you the long answer in a minute. But first, let’s talk about hope. It’s an emotion and a state of mind that touches every investor. If you learn to deal with it effectively, you can be a better investor and a better market timer.

When people invest in the stock market, they usually do so hoping that luck (or the economy or Alan Greenspan) will smile on them. Especially when you buy a stock, there’s lots of room for hope. Every stock has a story that may include takeover possibilities, terrific management, phenomenal earnings growth potential, turnarounds expected – or perhaps technological breakthroughs and revolutionary new products.

And always, there are some stocks that seem to bear out all that hope.

Earnings exceed expectations, some analysts put the company on their "recommended" lists (after the stock is already up 30 percent), the stock soars and the board of directors announces a two-for-one split. Investors can indulge in an emotional high that makes stock ownership great fun.

Even when things go bad, when competitors steal market share, the new product fizzles, management proves to be incompetent and analysts move on to greener pastures, there is still that story. If it was once true, maybe it could be true again. There’s always room for more hope.

By contrast, consider the plight of the market timer who knows his system won’t add value in bull markets. And even when timing works just the way it’s supposed to and shelters investors from the storm of a bear market, even that is an emotional challenge. Some investors are quite comfortable on the sidelines, knowing they have no downside risk. But others are anxious, knowing they’ll never make any significant money in a money market fund.

At its core, investing is the process of making financial bets on the future. And because the future is uncertain, there’s really no way to avoid hope. Investors who do not use market timing have to hope the market won’t lose 500 points in a day, as it did in October 1987. Those who do use market timing have to hope their timing system or systems will get them on the sidelines ahead of time if such a drop occurs. And that brings us back to our original question.

Back in 1987, our timing systems had us out of the market for almost a month before the big crash. Many of our clients were extremely glad they weren’t exposed to that unprecedented loss. We weren’t shy about pointing out that market timing had saved them from that loss, and some of them weren’t shy about pointing it out to their friends. But in fact, it was only incidental that our timing systems protected their money and ours from the one-day crash. Timing avoided most of the general market decline that started in August, which just happened to include that huge one-day loss. So the answer is: We can detect trends, but we won't necessarily dodge a one-day disaster.

Now leap forward in time to late winter, 1996. The market had been generally rising faster and farther than most experts expected. It hadn’t had a 10 percent decline in more than five years, making many old-timers increasingly nervous. Volatility seemed to be on the rise, but annualized rates of return remained in double-digits. Not many money managers want to miss out on those gains.

As the sun rose on March 8, 1996 all four of our U.S. equity timing systems were in the market. Early in the day, a favorable bit of economic news set off a major sell-off on Wall Street. It was almost as if a physician told a patient of a good test result, and the patient went into a funk suspecting the doctor would take him off of his addictive medication. On Wall Street, the physician seems to be the Federal Reserve, and the addictive drug is lower interest rates. In this case, the patient had made all his plans for the weekend based on getting more of that addictive medication. When it looked like the medicine might be withdrawn, the patient panicked. The bond market, fearing it would be deprived of the drug of lower interest rates, took a tumble. And the stock market fell into line, with the Dow losing 171 points, or about 3 percent. Measured in Dow points, it was the stock market’s third-worst day in history.

"All hope abandon, ye who enter here."
--Dante

If you were a money manager with millions of dollars of other peoples’ money in your care, what would you do? The first thing we did was to check our exposure. We manage bonds as well as stocks, and even though the stock market got all the publicity, in fact more money was lost in bonds that day than in stocks. Our bond timing system took us completely out of the market late in February. So on March 8, our subscribers lost no money in corporate bonds, lost no money in municipal bonds, and lost no money in government bonds. In fact, our bond model actually made a little money by collecting another day’s interest in money funds.

WAS THIS GREAT FORESIGHT?

It wasn’t foresight that got us out of the bond market on February 26. It was just the discipline of having and following a timing system based on mechanical factors. There are times we wish we had great foresight about the markets. But if we had guaranteed foresight and relied on it, I promise we would not have been 100 percent committed to U.S. stocks on the morning of March 8. Because we lacked that foresight, along with most of the rest of the investment world, we took the hit that Friday. And like everybody else who was paying attention, we wondered if this was just a blip on the screen or the start of "the big one."

After the dust settled, we found we had a sell signal from one of our four systems. We entered the market the following Monday still fully invested. That meant we participated in the Dow’s third-best day in history and recovered a good deal of Friday’s loss. By the end of the day we were 25 percent in cash, 75 percent in equities.

Shakespeare would have understood how we felt on Tuesday, when we got a second sell signal, leaving us 50 percent in the market and 50 percent out. This felt like a truly no-win situation for us. Put yourself in our shoes for a moment. What would you hope for in that situation? Would you hope the market would start going up again? If it did, your clients would only benefit by half. They might get pretty impatient with your timing systems. After all, if they were smart enough to hire you to manage their money, they’d be smart enough to figure out that your timing got them out of the market only after the damage had been done. Or would you hope that the market plunged again? That would make it clear that your timing systems were valuable. But your clients would still be 50 percent invested, and they would still be losing money!

At that point some market timers want the market to drop so they can protect their clients’ assets and perhaps "beat" buy-and-hold investors. Perhaps they think they will look really great by comparison to other managers because they’ll lose only half as much money. It seems pretty dumb to me to want to lose money just so other people will lose more.

In an ideal world, we’d be able to time the market retroactively, or at least get out at the first sign of trouble within the trading day. (In a really ideal world, the market would never go down, just up, and that would put us out of business!) But because we invest in mutual funds, we simply can’t do that. Mutual fund prices are set only once a day. Once you start the day invested in a fund, you’re in for the whole day. However, we can respond to the larger market movements we detect.

We could develop timing systems that could trade two to three times a week, and that might possibly improve our results. But the only mutual funds that would welcome this much trading are funds so desperate for money that we probably wouldn’t want to use them.

IS THERE ANY HOPE?

We hope the market continues its long-term upward trend. That will be good for everyone, and the general level of confidence in this trend is quite high. But we are certain that the trend won’t be in a straight line. There will be blips and bumps and thumps along the way. We are very confident our market timing systems will protect our clients from major market declines. But we can’t be sure they will.

Nobody in our industry can legally give you the assurance of the two words most investors want to hear more than any others: "It’s guaranteed." Even if it were legal, it would be irresponsible. We can’t even guarantee the safety of a money market fund. The one thing we can guarantee is that we will use our market timing systems and apply them diligently.

In a way, we agree with the American proverb that says "Hope is a good breakfast, but a bad supper." We hope the market will do well for investors, because ultimately that’s the only way they (and we) will make any money. But we know the bear is always waiting to pounce, and we feel a strong duty to protect the money we and our clients have made. Our timing systems let us sleep well at night. We hope they do the same for you.

 

 

 

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