Market Timing, Part I: Can It Be Done?

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 |  Includes: SPY
by: ReadTheTicker

The Private investor class is booming. The boom of the internet has delivered to readers of the web a mass of market information, investor advisory services, online brokering accounts, real time market data and security products such as ETFs and option chains.

The private investor now has access to advanced information to champion the market as the knowledge gap between the professional investor and the private investor is shrinking. This trend will only continue in the future as professionals recognize the demand from private investors for guidance and education via the internet.

If the reader takes the time to Google 'stock market timing' they will find many articles suggesting that the private investor underperforms the market and that the stock market cannot be timed. This is of course a myth: private investors can do just fine, along with the fact that the professional investor has been timing markets since the days of the Japanese rice traders.

It is true, that an individual must gain knowledge and skills to become a successful investor. An aspiring investor can only do this by making those that are more knowledgeable a partner in their quest.

Can the private investor outperform the market? Let's examine two schools of thought:

For the negative: Random Walk Theory:

The most popular thesis is by Burton Malkiel, a Princeton economist, who wrote an influential book called A Random Walk Down Wall Street (1973), which introduced the random walk hypothesis. Malkiel argues that asset prices typically exhibit signs of random walk and that one cannot consistently outperform market averages. Malkiel examines some popular investing techniques, including technical analysis and fundamental analysis, in light of academic research studies on both of these methods. Through detailed analysis, he notes significant flaws in both techniques and concludes that for most investors, following these methods will produce inferior results.

The random walk hypothesis is that price action has no predictive certainty. The past movement of a stock price cannot be used to predict its future movement. Or to put it a different way, past price action cannot predict future price action any better than 50:50 odds.

Therefore Malkiel's proposed investment plan is:

- That it is near impossible to predict which companies are worth investing in. He contends that chance can predict just as successfully as the experts. His solution is to select a widely diversified investment strategy such as investing in index funds (i.e. ETFs and stock funds like SPY, DIA or IWM).

- Malkiel says investors should place their money in a fund with a level of risk they are comfortable with, and then leave it until they retire.

- The individual investor should not use margin leverage.

A quote by Malkiel: "A blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."

Comment: This method is 'buy and hold' until near death do you part. Here is an example: On the 1st of January of each year (this date has been made up for discussion purposes), the private investor transfers savings into a stock fund that is made up of a very large basket of stocks (SPY, QQQ or IWM). In the Malkiel view, over the private investor's 40 year working life the returns accumulated by buying and holding are the best you can ever achieve as a private investor. The buy and hold strategy has the added benefit of low transaction costs, low taxes and low management fees.

Example: S&P 500 ETF SPY, 2007-2012

Click to enlarge

The random walk approach does also mean that you will most likely suffer draw downs (unrealized paper losses) for months, if not years. It is these draw down periods that are most likely to shake the private investor's resolve and force the investor to exit with potentially very large losses.

The random walk investment approach is valid and must be given due consideration. It is also the control test as to how other investment approaches measure up in comparison. If the private investor cannot outperform the senior indexes (Dow Jones industrials, S&P 500 and NYSE Composite Index) then the random walk investment plan is the better choice.

For the positive: A consistent approach.

The argument against the random walk investment theory is that within the basket of stocks that makes up the selected index fund (i.e. SPY) there are stock that are trending, and a selection of these stocks, with the application of sound money management, the private investor can outperform the market leading index.

There you have it. If the private investor can select stocks that are trending then the private investor can beat the leading market index. The private investor though requires methodology to select the trending stocks. The method must be proven over time and applied consistently and with discipline.

The chart below has an additional filter (i.e. stock is trending) to the random walk theory and as you can see the stock clearly outperforms the market leading index.

Example: Apple Inc (NASDAQ:AAPL), 2001- 2012

Click to enlarge

This is like comparing the board games of checkers and chess. Both are board games (the stock market), both require you to tactically dominate the other (security selection and strategy) but chess (with its consistent approach) is more complex than checkers (random walk) and requires more discipline to master. The private investor must decide which approach they wish to undertake.

Readtheticker.com's preferred method of stock selection is based on Richard Wyckoff's 5 point plan. This approach has stood the test of time. You can see Richard Wyckoff's work in some well-heeled investors like Jim O'Neil (CANSLIM), Linda Bradford Raschke, among many others.

In the end you must believe and trust the approach you select to allow you to master the markets. We hope the Richard Wyckoff logic makes sense to you as it does to us.

Part II to follow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The article has been written by the Managing Director of ReadTheTicker. ReadTheTicker is not receiving compensation for it (other than from Seeking Alpha). ReadTheTicker has no business relationship with any company whose stock is mentioned in this article