The Errors of Market Timing - Being Bullish As Stocks Fall

by: Marc Gerstein

Market timing stands at the crossroads of the Multi-market (regime switching) model I recently introduced. The goal is to have it switch strategies depending on whether market conditions are bullish or bearish. That's all well and good if the timing model works. Backtesting and recent real-time experience has shown it to function properly much more often than not. But if there's one thing we learned in 2008, it's the need to stay alert to the potential for new scenarios to arise. So no matter how sound the test results may be, it remains vital to inquire into what might happen if the timing model falters for a prolonged period.

Market timing gets little respect

One who is inclined to do any sort of market timing will have to gird for staunch opposition.

    Obviously, you don't have to be able to predict the stock market to make money in stocks, or else I wouldn't have made any money.

Lynch, One Up On Wall Street (Fireside, 1989), page 84.

    Graham said, "The farther one gets away from Wall Street, the more skepticism one will find as to the pretensions of stock-market forecasting or timing." Since Omaha is a good distance from New York, it's not surprising that Buffett gives zero credence to market predictions. Buffett cannot predict short-term market movements and does not believe that anyone else can. He has "long felt that the only value of stock forecasters is to make fortune tellers look good."

Hagstrom, The Warren Buffett Way (Wiley, 1995), page 51.

As recently as the past few days,, an ETF-oriented site I read daily and for which I have enormous respect, weighed in vigorously against those who say buy-and-hold is dead.

    I keep reading articles about how "buy-and-hold is dead." That's laughable. If there were ever a time for buy-and-hold, that time is now.

Matthew Hougan, 2/4/09

    The other issue is that people like Tommy Lydon and Bob Pisani and even us to a degree, Matt, make their living off of the catchy story, off of selling people on the idea that we know something or know someone who knows something that can help them time the market, to avoid a catastrophic downturn or to catch the crest of the next wave.

    The thing they won't tell you generally, but that Matt just has, is that it's all a fool's game. The market is a zero-sum game generally-but there's one part of it that is not. And that's that your costs are coming out of your returns and going into the pockets of whoever is charging the fees.

Jim Wiandt, 11/5/09

Many can produce charts and tables showing how, over a long time period, the probabilities favor superior results for those who can buy and hold. But that's small consolation for those to need to disinvest at the wrong time, such as retirees who must put demographic considerations ahead of investment philosophy. And by the way, this is not just a simple example. In the years ahead, we're going to find out exactly how much of the last generation's bull market resulted from investment inflow relating to post WWII baby-boomer savings, and the extent to which future market trends will reflect movement to a different demographic situation by those now-older baby boomers.

And with all due respect to Peter Lynch, he hasn't managed money in such a manner as to have been tracked publicly since he stepped back from Fidelity Magellan in 1990, so we have no idea whether he'd have continued to succeed despite being unable to predict the stock market. Other once-revered gurus have faltered. Witness, for example, William Miller, who had a nearly twenty-year record of excellence wiped out in just one. The 12/11/08 Wall Street Journal quoted Miller as acknowledging "The one thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis."

As to the Hougan and Wiandt comments, I actually agree with an important issue they raise; that now may be the worst time to jump ship. As I mentioned in my previous article introducing the regime-switching strategy, the super-bear portion of the model, the one that's raising cash now instead of reinvesting new funds into equities, is one of the components I'm watching especially closely with an eye toward possible revision. The market has already experienced a major trauma and this moment in time may actually be a good one for simply backing up the truck, loading up on good stocks, and sitting tight. But that's now. Assuming that scenario pans out, it may be much more dangerous to stick with it one, two, or perhaps three years down the road.

Defining the task

The most important point that all the market-timing critics make is the inevitable difficulty, or futility, of successful implementation.

That is why the market-timing section of the Multi-market Model has been implemented with full consideration of the burning question: What if I'm wrong.

There are two categories of errors. One is being bearish when market conditions turn good (the issues that most concern Hougan and Wiandt right now). The other is being bullish when stocks are about to head south, a wound that's all-too-fresh for too many investors. This article will address the latter class of mistakes. A subsequent piece will address the former.

I start with a determination to refrain from using market timing in a way that places a big "bet" on the chosen strategy. For example, I'm not looking to decide whether to go long or short. On paper, the idea of flipping between long and short to produce gains regardless of market direction is incredibly appealing (the hedge-fund dream). If I were confident I had a method that could help me do that with an acceptable degree of success, I'd implement it in a heartbeat. But I'm not there. Unless or until I can develop such an approach, I'm long only.

Also, the mainstream portion of my timing model is not even being used to allocate between stocks and other assets (cash or fixed income). It's all stocks all the time, the difference being the kinds of stocks pursued depending on whether the model is bullish or bearish. The presently-active raise-cash mandate comes from an add-on that, as noted, is very much under review and will be discussed further in the next article.

Being bullish on the way down

When the Multi-market model is bullish, it will invest in the top 10 stocks and hold them unless the rank falls below 90 (out of 100) in which case it will be sold and the proceeds will be reinvested into a different now-qualifying stock (all this subject to some basic liquidity filters). The ranking system I'm using is based on the following:

  • Growth factors
    • Year-to-year EPS Growth in latest quarter
    • Year-to-year EPS Growth in trailing 12 months
    • EPS Growth Acceleration: Latest quarter versus Trailing 12 months
  • Sentiment factors
    • 4-week EPS revision in current-quarter EPS estimate
    • 4-week EPS revision in current-year EPS estimate
    • 4-week EPS revision in next-year EPS estimate
    • Average analyst recommendation
    • 4-week change in average analyst recommendation
  • Value factors
    • Earnings Yield
    • Price to Book
    • Price to Sales
    • Enterprise Value to EBITDA

All three groups of factors are weighted one-third. All of the factors within a group are equally weighted.

As you can see, this is nothing exotic. It taps into the usual things investors like to see during bull markets, different ways of measuring near-term EPS growth, tempered to keep valuations from getting too far out of line. The question for today is what happens if we get caught using this system during a bear market.

Table 1 summarizes the results of a backtest (assuming weekly rebalancing and 0.05% price slippage per transaction) covering the past year, a time when the S&P 500 fell nearly 40%.

Table 1: 2/6/08 - 2/5/09, Weekly rebalancing

Portfolio S&P 500 Excess
Up Weeks, Avg. % change 4.61% 3.02% 1.59%
Down Weeks, Avg. % change -3.04% -3.06% 0.02%
All Weeks, Avg. % change -0.15% -0.76% 0.61%
100 at start grew to . . . 64.9 63.1 1.8
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Table 2 focuses more closely on the fourth quarter of 2008, an especially damaging period for the market.

Table 2: 9/30/08 - 12/31/08, Weekly rebalancing

Portfolio S&P 500 Excess
Up Weeks, Avg. % change 11.19% 5.57% 5.61%
Down Weeks, Avg. % change -5.97% -5.16% -0.81%
All Weeks, Avg. % change 0.16% -1.33% 1.49%
100 at start grew to . . . 87.1 80.0 7.1
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The model outperformed on average during up weeks, which is what one would hope it would do. But on the whole, full-period losses of this magnitude are not something we ever want to see. But consider the nature of these tests. We're pretending we had a market-timing model that went dead and left us bullish each and every week during a period when the market was experiencing an epoch plunge, one that may leave its imprint on our financial and political culture for a generation or more. In that context, the overall results, which are in line with the S&P 500 (the classic passive buy-and-hold benchmark), seem tolerable.

Tables 4 and 5 show what would have happened had I rebalanced every four weeks instead of once per week. These results will look bad.

Table 4: 2/6/08 - 2/5/09, 4-week rebalancing

Portfolio S&P 500 Excess
Up Weeks, Avg. % change 7.20% 3.95% 3.25%
Down Weeks, Avg. % change -8.29% -6.63% -1.66%
All Weeks, Avg. % change -2,76% -2.85% 0.09%
100 at start grew to . . . 52.4 63.1 -10.7
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Table 5: 9/30/08 - 12/31/08, 4-week rebalancing

Portfolio S&P 500 Excess
Up Weeks, Avg. % change 10.78% 5.56% 5.22%
Down Weeks, Avg. % change -24.37% -14.93% -8.53%
All Weeks, Avg. % change -6.34% -4.69% 1.66%
100 at start grew to . . . 69.1 80.0 -11.9
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The outcomes we see in Tables 4 and 5 were not much different even when I increased the portfolio size from 10 stocks to 25.

Clearly, if we are to contain the impact of market timing errors, we need to stay alert. Even a sound ranking system won't protect us unless we act quickly to address whatever bad choices we do wind up making, to at least rotate into alternatives that are less bad. Weekly rebalancing facilitates that. It also limits the opportunity to benefit from good choices, but when the market is plummeting, that concern doesn't seem so pressing. Of course this was an exceptionally bad sample period. The need for weekly rebalancing during more "normal" declines is not so clear.

Generally, though, the key here is not so much in what I'm doing with the bullish portion of the model as what I'm not doing: Specifically, I'm not shooting for the moon trying to max out on the upside with momentum, leverage, etc. The Growth and Sentiment groups of factors are mainstream efforts to latch onto that which usually appeals to investors during normal times. The Value Factors in an effort to keep the portfolio at least somewhat anchored in common sense even during the headiest of days. And, I'm containing the worst errors by re-balancing weekly.

This specific model is by no means the last word on the topic. But I would at least hope critics can see that this is an area worthy of further study, rather than something that should simply be dismissed it out of hand.

Suppose the model turns bullish today

In addition to looking at test results, we can also get a sense of what a model is doing by looking at the individual stocks it would put into a portfolio. On that basis, Table 5 shows the ten stocks that would be purchased now if one were to start using the model today (with weekly rebalancing) and if the market-timing section was bullish.

Table 5

Top-10 bull-strategy stocks
Companies Industry
Rent-A-Center, Inc (RCII) Rental & Leasing
Innophos Holdings, Inc. (IPHS) Chemical Manufacturing
Jarden Corporation (JAH) Appliance & Tool
NRG Energy, Inc. (NRG) Electric Utilities
Apogee Enterprises, Inc. (APOG) Constr. - Supplies & Fixtures
Live Nation, Inc. (LYV) Casinos & Gaming
Sauer-Danfoss Inc. (SHS) Misc. Capital Goods
Foot Locker, Inc. (FL) Retail (Apparel)
KHD Humboldt Wedag International (KHD) Constr. & Agric. Machinery
EnerSys (ENS) Electronic Instr. & Controls
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Rent-A-Center (NASDAQ:RCII): This company is in the rent-to-own business which refers to big-ticket items, mainly furniture but also, nowadays, consumer electronics, that can be rented instead of purchased outright. Actually, it's assumed that many of these rental agreements will convert to ownership at some point. This is not something that will appeal to mainstream consumers, but it is a way for people with low incomes and/or poor credit to acquire big-ticket things that would otherwise be unavailable. The company expects targeted advertising based on the constrained-budget theme to help keep same store sales trends in the zero to minus two percent range for 2009, and tight control of collections is expected to help EPS grow form $2.08 to $2.15-$2.32.

Innophos Holdings (NASDAQ:IPHS): This is the leading North American specialty phosphate producer. These are used to produce specialty salts for food, beverages, pharmaceutical tablets, toothpaste abrasives, and asphalt; purified phosphoric acid for beverage flavoring, and STTP and other products for detergents and fertilizers. EPS gains were astronomical in 2008 due the way things worked regarding pricing for raw materials and end products. Pricing reversals are likely in 2009, so it is expected that EPS will fall from sharply higher and obviously unsustainable levels. The diversity of end markets and progress in de-leveraging a debt-heavy balance sheet makes this an intriguing investment. But realistically, it's unlikely to continue being high ranked in the here-and-now ranking systems I'm using. That doesn't mean I should regret seeing IPHS on the list. But it does suggest that this needs to be viewed as a short-term trade that will likely be unraveled in one of the upcoming weekly rebalancings. (But it may be a successful trade. The likely decline in 2009 EPS is well understood by the market and the stock has been showing some strength.)

Jarden (NYSE:JAH): This firm produces a wide variety of small-ticket (usually priced at or below $30) basic consumer products such as humidifiers, blenders, coffee makers, vacuum packaging, warming blankets, matches, toothpicks, playing cards, rope, baseball gloves and balls, lanterns, fishing gear camping gear, and so forth. JAH is number one or two in most markets and is gaining share. That said, the economy has sustained so much damage, JAH is unlikely to avoid experiencing a revenue decline in 2008. The slide in EPS anticipated by analysts is not too harsh and judging from the results of the ranking system I'm using, a lot of other companies are expected to fare much worse. As an example of something I might own as the result of a timing error, I could live with it.

NRG Energy (NYSE:NRG): This is a wholesale power producer with reasonable numbers but one which may not be around long. Exelon (NYSE:EXC) is trying to acquire it in a hostile transaction. It's hard to say what will happen, but right now, the stock doesn't seem inflated to the point of raising substantial downside risk if no deal materializes, and there is the possibility the deal will go through (presently, NRG is trading 1about 12% below the value of EXC's stock offer) or that EXC will raise its bid. For the model, as with IPHS, this may be just a short-term trade.

Apogee Enterprises (NASDAQ:APOG): This well-regarded glass maker has grown well in the past, but it's strong presence in architectural glass is likely to cause EPS to decline in the year ahead. The company expects cost-cutting to moderate the decline and for now, a strong backlog is giving the company a chance to wait out the passage of time before it actually declines. The rating system used here does compare one company to others so if APOG's decline is sufficiently gentle relative to others, that, coupled with a modest valuation, could keep the stock in the portfolio for a while. Clearly, I'd rather not own this stock in a bear market. But as far as timing errors go, I probably could do a lot worse.

Live Nation (NYSE:LYV): This is the dominant promoter of live-music concerts and is a major manger of entertainment venues and also managers artists. It's involved in ticketing, too, but is hoping to merge with TicketMaster (TKTM). It remains to be seen if a deal like this will pass Federal antitrust muster under the new administration. But in any case, LYV is big time, and it benefits from a diverse stream of concert-related revenues (including merchandise sales). One can, and should, wonder how the recession will impact the willingness of fans to engage in this kind of spending. Bulls maintain a person only does this once or twice per year and may, therefore, feel that splurging is still feasible. We'll see. But it's not as if LYN is the only company whose numbers are vulnerable to the economic situation. It looks like a worthy choice for the bullish version of the Multi-market model.

Sauer-Danfoss (NYSE:SHS): This company is about as cyclical as it gets: hydraulic systems for use in mobile equipment, such as gears, pistons and steering mechanisms. Guidance for 2008 went down in December from $1.15-$1.25 per share to 75-85 cents. It's easy to imagine 2009 numbers coming down as well. This is not a stock I'd want to own in a bear market, but that's not how its coming to our attention. As with the others on this list, it's here because of an assumed erroneous market-timing call. The company itself is fine and I'd be content to own it at many points in time. For now, it's an apt illustration of timing gone wrong. But again, it's not a disaster. It's not the sort of firm likely to implode on the way down, and as errors go, it's early-cycle qualities (causing it to be up sharply in the market's rally as this is written), could make for a good result for the wrong reason.

Foot Locker (NYSE:FL): This well-known purveyor of athletic footwear, etc. is another stock I'd really prefer to not own in a bear market. Business is bad and estimates have been dropping. And again as with SHS, it's in the portfolio thanks to a timing error but one which might work out after all. Thus stock too is jumping briskly as it is also being seen as an early cycle stock.

KHD Humboldt Wedag International (KHD): This Hong Kong based firm makes cement, concrete and related mineral processing equipment used for emerging-country infrastructure products. For now, conditions are tough and the company is hunkering down to conserve cash. Long term, I love the idea of playing emerging world infrastructure. Right now, the timing is doesn't work, but if this company is an example of the punishment I'd sustain for a market timing error, I can cope.

EnerSys (NYSE:ENS): At first glance, this is a very dull cyclical play: industrial batteries. From an investment point of view, dull and cyclical is not necessarily bad, and if timed right, it can be downright good. But ENS offers another angle: the possibility of cashing in on plug-in hybrid electric cars. I don't know how substantial this could be and am not inclined to debate the topic right now. But for what it's worth, this company has been growing nicely and as timing errors go, I could imagine many that would be worse.

By any sort of qualitative criteria, this would clearly be a bull-market portfolio. And frankly, in the sever environment we experienced just recently, I can see why I'd be leery about staying with a timing error for as long as four weeks. That said, these are, on the whole, decent companies and some seem to be early-stage recovery plays. As sentiment regarding stimulus and turnaround prospects evolve, it would seem that holding such a portfolio now, even with four-week rebalancing, might not be such a disaster as to justify the fear and/or disdain felt by so many to market timing simply because it's hard to always be right. We wouldn't want to be wrong too often, but if a timing model has a reasonable batting average, this seems like a tolerable penalty for error.

Next time, we’ll see what might happen if we wind up bearish when we should be bullish.