Alpha Power Investing Newsletter

September 20, 2011

Market Timing

"Market timing doesn't work."

That's the official mantra of the investment industry's mainstream. It's been repeated over and over so many times that the expression "market timing" has become permanently tainted.

One of the industry's main arguments for this claim has remained unchanged for the past two decades. It's called "the best days" example. I just got a brochure from one of the big mutual fund complexes which cites it. You've probably heard it too ... it goes like this: Stay fully invested and don't try to time the market because if you miss the best days your returns will be poor.

That's it. No argument, just the illustration. The inference is that market timing is bound to miss the best days and that is devastating to returns.

In Logic 101, this is called the "straw man" fallacy. This fallacy consists of setting up a "straw man", which is an easily defeated proposition, then identifying your opposition with the "straw man".

In the illustration above, a "market timer" is someone who misses the best days but is fully invested in all the other days of the period examined (in this case, 20 years!).

Based on this example, I feel very confident in stating that market timers do not exist and have never existed. I am simply amazed that the industry keeps dragging out this spurious and worn-out illustration of the dangers of market timing.

In the same brochure, an interesting and profound illustration is cited:

This illustration, which originates from DALBAR, an investment research company, is based on the behavior of mutual fund investors. It documents the effect of investor trading in mutual funds. DALBAR's work, which is based on an analysis of cash flows into and out of the universe of equity funds, convincingly proves that the average mutual fund investor dramatically underperforms the market due to "switching" from one fund to another in an attempt to profit from the hot trend or the hot manager. In most cases, this results in buying past performance late in the game, then suffering as performance reverts to the mean. This study, however, is not about market timing at all, but about chasing performance and to claim that it shows how market timing doesn't work is just downright misleading.

As long-term readers know, Alpha's Mid-Cap Power Index Managed Account program is based on a simple "market timing" strategy. In simplest terms, the strategy is this: each year own the S&P MidCap 400 Index from November 1 to May 31, and then own conservative bonds the balance of the year. We use the Barclays Capital Intermediate Treasury Index as the bond component in our "Mid-Cap Power Index".

So I ask you, what's not working here - market timing or buy and hold?

To be perfectly honest, I agree that market timing, as it is practiced by the majority of investors, doesn't work. Numerous empirical studies show that the majority of equity investors regulate their market exposure by the "rear-view mirror" approach; that is, they up their exposure when the market has displayed a clear rising trend and reduce exposure after a clear declining trend has established itself. This "bandwagon" effect reflects the emotional basis of most investor decision-making.

Every investor who wishes to do well over the long-term must recognize that human psychology pushes us in the wrong direction when it comes to "buy low" and "sell high". Good investors are contrarians who move against the dominant emotions of the crowd and see the emotional excesses of the majority as a profit-making opportunity. As a result, good investors are in the distinct minority - a consequence demanded by common sense.

In order to escape the "bandwagon" effect, ordinary investors can join the ranks of the elite by turning control of market exposure over to a systematic, calendar-based discipline which exploits the cycles of human psychology. The Mid-Cap Power Index, for example, exploits the annual tendency of the stock market to "skew returns" into the six to seven month period from November to May/June. This long-term skewing effect is largely caused by the year-end optimism of investment "experts" who confidently predict the outcome of earnings, interest rates, etc. over the next calendar year. Their confident optimism causes the overall investment climate to be elevated for several months thereafter as their followers direct money into riskier assets. This phenomenon is global, affecting over 30 developed foreign markets, inasmuch as investors everywhere have the same psychology.

The Alpha Mid-Cap Power Index Managed Account seeks to duplicate the results of the Mid-Cap Power Index after fees and expenses. For more details about this tactical strategy, go to the Programs and Performance section of our website at www.alphaim.net and click on the corresponding link to read the brochure.

If you would like to discuss this or any of our investment programs, please call me at 1-877-229-9400.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11

Past performance is not a guarantee of future performance.

 
© 2011 Alpha Investment Management, Inc.
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