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Many income investors have been taught to believe that “market-timing” is anathema to their investment objectives and/or that it can’t be done successfully (“nobody can time the market”). I will argue that this piece of conventional wisdom is false, and that it is dangerously false.

In a three-part series of essays, I will argue that market timing needs to be incorporated as a fundamental component of income investing. I will demonstrate why market timing is important, when it should be applied and how it should be implemented.

I want to make it crystal clear from the outset that when I am referring to “market timing” in the context of income investment, I am not referring to day-trading or frequently jumping in and out of the market. I am referring to conservative and time-proven strategies that can be specifically tailored to the income investor.

Ability To Buy Low and Sell High Determines Income Level

Many people identify buying low and selling high with capital gains. However it is even more important for income investing.

Imagine a bull market in which a high quality stock trades for $80 and which pays a $1 quarterly dividend for an annualized divided yield of 5%. If that same stock could be purchased in a market downturn for $57 – a 29% reduction in price – the same stock would now yield 7%.

A stock that yields 7% will provide an investor with 40% more income each year per dollar invested (relative to the same stock yielding 5%) – potentially for decades. Needless to say, a 40% difference in one’s income or standard of living over many years makes a tremendous difference. It can literally change a person’s life.

To obtain 40% more income it is necessary to buy a stock 29% lower. Equity markets (^SPX, ^DJIA, ^IXIC) usually provide several opportunities during the course of a decade to avoid large market declines and purchase stocks after a decline of 29% or more.

Successful Security Selection For Income Is Largely A Matter of Good Market Timing

Many pundits teach that income investing does not require market timing. According to these pundits, successful income investing is merely a matter of purchasing quality bonds or stocks at good prices (i.e. high yields).

The assumption behind this school of thought is that at any given point in time, there are always worthy stocks and/or bonds that are for sale at “good” prices.

This is largely a fallacy. Good stocks or bonds are mainly found at “good” prices when the overall market for stocks or bonds have fallen substantially.

Good stocks or bonds are rarely found at “good prices” – i.e. with good yields -- in “normal” to bull market conditions. In “normal” market conditions and in bull markets, it is generally only somewhat marginal stocks and bonds that sport high yields. In normal to bull markets, to stretch for yield, one must climb further down on the quality ladder. This implies that the safety of the dividend and potential growth of the dividend will be sub-par.

Can good stocks or bonds be purchased at good prices (i.e. high yields) during normal or bull markets? Sure. However, the investor’s chances are reduced dramatically.

During normal or bull markets high yields are usually a warning sign – not a buy signal. In normal and/or bull markets, stocks and bonds that are cheap (i.e. high yielding) are usually cheap in relative terms for very good reason. It is likely that the dividend or coupon is not safe and/or that future growth of the dividend will be sub-par.

Unfortunately, income investors that are indifferent about market timing and yet seek a specific level of income will tend to be stuck with stocks or bonds with above average risk and below average growth of dividends.

If investors can avoid major bear market declines in income producing assets by making wise asset allocation shifts between stocks, bonds and cash, the income generated over time can be greatly increased.

I will remind investors that various studies have shown that well over 50% of excess total returns (higher than benchmark) achieved by investors that are able to obtain them are due to market timing. Many of those investors are not consciously trying to time the market. However, they are buying low. And in general, good stocks and bonds are mostly available for low prices in bear markets.

Dollar Cost Averaging

“Dollar cost averaging,” is a strategy premised on the assumption of futility and/or incompetence. It assumes that investors cannot tell the difference between attractively valued assets and unattractively valued assets.

For those investors that have such a low opinion of their abilities, dollar cost averaging certainly beats buying stocks and bond at the top. However, this strategy is clearly inferior to buying stocks and bonds near a bottom.

Furthermore, dollar cost averaging sounds great in theory, but often fails miserably in practice for two reasons.

First, stocks and bonds can stay overvalued for long periods of time – sometimes a decade or more. Dollar cost averaging during such periods will place investors in such dire straits that they may never be able to recover. For example, it took investors that dollar-cost averaged into long-term bonds during the 1960s many decades to simply get back to “even” in inflation-adjusted terms. Similarly, investors that dollar cost averaged into stocks since 1996, on average, are “underwater” in inflation-adjusted terms (calculating total returns on the S&P 500) as of August 31, 2011.

Let us take another example. Long-term Treasuries (^TNX, ^TYX) have outperformed virtually all asset classes for most of the past 30 years. However, for reasons that I have explained in detail here and here, it is overwhelmingly likely that long-term Treasury bonds will perform poorly in absolute and/or relative terms over the course of the next decade. Indeed, given the prospects of increased inflation over the next decade, it could take 20 or more years of disciplined dollar cost averaging for an investor in long-term Treasury bonds to simply get back to “even” in inflation-adjusted terms. Indeed, with inflation currently well over 3.0%, investors in 10Y Treasuries are already losing ground in real terms today.

In sum, timing matters.

The second cause of failure of dollar cost averaging strategies relates to the first: How many people are willing to patiently apply a strategy of dollar cost averaging while sustaining inflation-adjusted losses over 10, 15 or 20 year stretches? The answer is virtually no one. 99.999% of investors will throw in the towel before the tide turns in their favor. And most of them will be throwing in the towel when the asset class they are dollar cost-averaging into is near the bottom.

Dollar cost averaging is not what it has been hyped up to be. First, it requires a substantial amount of luck –i.e. the investor needs to be lucky enough to begin dollar cost averaging when asset prices are fair to low. Without this sort of luck, success in dollar cost averaging requires a sort of heroic patience that virtually nobody possesses.

Successful market timing is not based on luck. It is also does not require investors to have a heroic psychological disposition to absorb losses for multiple years and even decades. Market timing is based upon time-honored and proven principles of value and momentum.

What About Lost Income?

Market timing requires asset allocations shifts. Occasionally shifts will have to be made out of high-yielding assets to low yielding assets. Let us take our example above. Assume that based on solid fundamental and technical criteria an investor sells a stock yielding 5% and invests the proceeds in assets yielding 1% on average. Assume a dividend growth rate of 5% per annum. The investor expects a stock decline of 29% or more. Can the investor afford to lose the income in the interim?

In the example above, an investor could afford to wait for about six years of “dipping into capital” before “buy and hold” outperforms the strategy of waiting for a 29% or more decline.

How likely is it that buy and hold would ever outperform a market-timing strategy of waiting for a 29% decline?

First, the chances are virtually zero if certain basic rules of valuation and momentum that will be described in Part 3 are applied with rigor.

Second, no serious market timing system would advise an investor to make an asset allocation shift out of high yielding assets and into low yielding assets and passively wait for six years. Market timing is not about “sell and hold.” A serious market-timing system would “stop in” after a relatively short time if the sell signal has not worked. Based on various criteria. Exactly how this can be done will be described in Part 3.

Can Market Timing Help Those That Refuse To Ever Employ It?

Some investors will not be convinced that they can time markets effectively. They will prefer to assume that they will always be incompetent and will forever be unable to tell the difference between attractively valued assets and unattractively valued assets. They may also prefer to assume that even if they could make such determinations that they would not be able to overcome the opportunity cost of switching from high yielding assets to low yielding assets for relatively short periods of time.

Even for those investors, familiarity with market-timing principles and analysis can prove to be extremely useful. During times of crisis, having paid heed to good market-timing analysis will prepare investors for the volatility of the market. An investor that is prepared for volatility and its potential causes will better be able to deal with it. Investors that pay no heed to market-timing analysis can get caught off guard by extreme volatility. This sort of unpreparedness can lead to panic and poor-decision making when the inevitable crises arrive.

When warned of a potential decline, the investor that has consciously decided to hold his/her stocks and bonds despite the warnings will be better prepared to ride out the decline than an investor that had no idea it was coming or why.

Thus, even if an investor is totally committed to a passive dollar cost averaging and/or buy and hold strategy, paying heed to good market timing analysis will psychologically assist the investor in executing their designs.

Conclusion

Investors need to understand that the principle of “buy low and sell high” applies to income investing just as much as to other styles of investing – perhaps even more so. Timing is critical to income investing because the income that is generated from a given quantity of capital invested is primarily a function of price. A relatively modest difference in purchase price can make a very large difference in income over time. For example purchasing a dividend producing stock such as T or VZ 16% below a given price level will result in a 20% increase in annual income – potentially for decades. Purchasing a dividend producing stock such as INTC or PEP for 29% below a given price level will result in a 40% increase in annual income – potentially for decades.

Acquiring a well-diversified portfolio of quality investments at low prices (high yields) usually requires making purchases during bear markets. It is very difficult to acquire a well-diversified portfolio of high yielding assets at attractive prices and yields when an entire asset class is fairly valued or over-valued.

Indeed, stretching for yield while long-duration income-producing assets are overvalued is a recipe for potential disaster as investors tend to be drawn to risky assets that will underperform when the interest rate cycle turns.

The time function is very important for income investors. Income investors do not like to sacrifice income for very long. However, by definition, good market-timing strategies actively manage the time function in the process of maximizing price (yield). As its name implies, market timing does not just seek a good price; it seeks to obtain it at the right time and for the lowest possible opportunity cost.

For most income investors, market-timing decisions will be rare. Perhaps between one and four such crucial occasions will present themselves per decade. In the next article in this series, I will explain when income investors will need to make market-timing decisions.

Disclosure: I am short TLT and long TBT and SBND

Source: Market-Timing Should Be A Fundamental Component Of Income Investing: Part 1 - Why