On Wall Street, no topic generates more discussion and debate than whether the market trend is about to shift. Here is my preferred method to market timing:
The primary goal of many market participants is to predict market direction. They want to predict the twists and turns and call bottoms and tops. This can be such an obsession that making money and producing good returns become secondary matters.
Great market-timing calls are celebrated on Wall Street, so the benefits of doing this are obvious, but there has never been anyone that called tops and bottoms with great precision over a long period. Several of the folks that "called" the crash in 1987 built careers on their foresight, but never repeated the feat again.
One reason that there is so much focus on market timing is that stocks tend to move in a correlated fashion. It has been estimated that roughly 80% of stocks will move in the same direction as the indexes, but this can vary wildly, and there are many times when individual stocks and various market sectors don't correlate to the indexes at all. Recent market action has been a great example of how stock picking can be a better approach than market timing.
Good market timing can help to put the wind at your back when trading. It is always easier to trade with the overall trend and if you are confident in market direction, you can be more aggressive at buying or do a better job of playing defense.
There are three basic ways to approach market timing. I have a fourth approach that I will outline at the end of this article.
The Big Idea: Macro Approach
The first main market timing approach that we hear about in the business media more than any other is the macro approach. This is an attempt to use economic data, valuations, earnings estimates, price-to-earnings ratios, interest rates, politics, currencies, pandemics, and an endless number of other factors to determine if the market is ready to make a turn.
Pundits love this sort of analysis as it allows them to parade their great insight, brilliant research, and impeccable logic. There is a myriad of creative ways to look at all this information and, in the past, sometimes there even are causative factors at work.
The problem with this approach, like many things in the market, is timing. There is no way to know when these factors might matter to the market. As the old saying goes, "the market can remain irrational far longer than you can remain solvent." Just because you have a great argument on why market conditions have to change doesn't mean it will happen.
A second popular way to time the market is to use a contrarian approach. The theory here is that when everyone is very positive or very negative, the market has to change direction, because there is no longer any fuel, in the form of buying power, to keep things moving in the same direction.
There is a certain appeal to going against the mindless crowd of investors that fail to approach the danger that must lie ahead. It is hard to be smarter than the unwashed masses if you are running with them.
Contrary market timing has the same major problem as the macro approach to market timing -- it is nearly impossible to time it with any precision. After a top has already occurred, it is always easy to point out the clear excesses that existed, but there are so many false positives along the way that it is a useless tool.
Contrary thinking is very easy to engage in, because there are always some aspects of the market that seem obsessive and excessive. For example, we always hear bulls say there is cash on the sidelines and therefore the market can keep running up. It has proven useless as a timing argument.
Currently, we have many "experts" characterizing the action as a bubble and warning us that it will end badly. They will be proven right at some point, but don't count on their timing as being very good.
Off the Charts
The third way to time the market is to use charts. This is a much more effective way to approach market timing rather than formulating some sort of thesis, but there is a tendency to make it far more complicated than it should be. The problem is that market timers always want to make their calls at the exact moment that the market hits a turning point.
When you try too hard to be precise, the risk of error increases greatly. The only way to be extremely accurate is to be early. You can't call an exact top or bottom after the fact, so you will miss out on the glory of a great call, but you also incur substantial opportunity cost if you are sitting on the sidelines for months, because the market is "overbought'' or "extended."
In the last 25 years, there have been two major bear markets and several short-lived corrections. If you had avoided the bulk of the bear markets in 2000-2002 and then in 2008-2009, it is very hard not to have produced superior returns. The key to avoiding them was to simply watch the trend lines and when they were broken to move out of the way.
There is no question that you will suffer some losses if you wait for a trend break to occur, but the benefit of staying in the market as a trend continues longer than is expected will offset the damage you incur at a turn.
It is always easier in the rear view mirror, but this chart of the S&P 500 shows how trend lines are the key to market timing.
If and when trendlines start to break, that is the time to pay attention to the macro-pundits and their bearish arguments. Wait for the price action to provide some hard evidence of a change in the market character before you embrace the negative narratives.
Where to Look? Your Own Stocks
If we can't trust the "experts" to give us good advice about a market turn. then who do we trust? My answer is that we look to the stocks that we own. There is no better market indicator than your portfolio. The stocks that you own will tell you what to do. When they start to act poorly, it is time to sell and when they are acting well, it is time to buy more. Simply look at your profit and loss statement and when you are losing money, then it is time to take some action.
If you apply this approach rigorously then you don't need to worry about all these complex big-picture arguments. When you sell stocks that are slipping, you will automatically raise your cash levels. The weaker they are the more you sell and the more insulated you are from poor market action. At the same time, you keep looking for new stocks to buy. If you can't find good ones then that is a pretty good clue that a market correction is occurring.
Like most things in the market, the theory is much easier than the application. This approach doesn't work if you find reasons to not sell stocks that are acting poorly. That is by far the biggest problem that most market participants face. They simply don't want to give up on a precious stock that they think is going through a temporary bout of weakness. They are emotionally attached and too willing to forgive bad behavior.
As is so often the case with effective trading, the key is to have a plan and the discipline to stick with it. If you sell stocks that are weak and break support and only buy stocks with "good" technical patterns, then you will be positioned more defensively as the stock market goes through a corrective cycle. Avoiding major losses is the key to all market outperformance.
It is always possible to formulate a very compelling bearish argument but the only timing that matters depends on price action. If you let your stocks be your main indicator of market health then you don't have to worry about those complex macro arguments.
The biggest drawback to this approach is that market players will sell, but then fail to rebuy when technical conditions turn back up. "I never got back in" is one of the most common laments when a trader takes an active approach to manage their positions. The only way to deal with that is to have a set plan and make sure you execute. When you sell make sure you have a solid plan for buying back those shares should conditions change.
I have no idea what this market is going to do next and none of the experts do, either. I am, however, very confident that I can manage my positions tightly and keep my accounts fairly close to their highs no matter what may happen. I have no fear of a major market correction. I root for corrections to occur as they will create some great opportunities. That sell button works very well and is easy to undo.