It’s high time that financial gurus admit that market-timing strategies—especially those that portend to capture all of the upside and none of the downside of the stock market—are an illusion.
Over the past 100 or so years, there have only been a handful of bear markets, characterized by a fall of 20% or larger, that most people called out as a beginning or end of market cycles.
Most of those examples had similar symptoms—pain from drawdowns. But some took longer to recover and some were short-lived. Some were shallower than others. Just like snowflakes, they are all alike yet unique at the same time.
Studying market behavior for patterns can be limiting. And while history can be reviewed, most finance professionals have experienced less than five corrections in their lifetimes.
Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, explains the reason why people still attempt to make market-timing calls. “You can get famous for getting it right. Also, there is demand for such calls, as investors want ‘certainty’ and crave prognostications.”
But chances are even the “correct” calls are correct only by luck, according to Alex Gurevich, chief investment officer at HonTe Advisors.
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“Even though some gurus have accurately pinpointed market tops, their long-term performance has not been all that great, because there are only a few of these calls you can make over your professional career,” said Gurevich.
Where do market-callers focus their attention? Some tap fundamentals, many rely on chart know-how. Some combine both, while others insist on never using both at the same time.
Valuation, earnings and profit margin
As for fundamentals, price-to-earnings ratios are one of the more commonly used metrics for valuation. They’re currently at relatively extreme levels historically and, yet, the broader market remains near record highs were it’s stood for some time. PEs are stretched whether you look at pro-forma, equal-weighted, median, non-financial or a cyclically adjusted basis. Other valuation metrics, such as price-to-sales or enterprise-value-over-operating-earnings, are also above the levels of most other market peaks.
Historically, peak valuations have coincided with market tops, but their predictive power is near zero.
“When price-to-earnings ratios are high, there is a good chance that the market has a positive momentum that can continue for some time. This makes short-term forecast unreliable,” said Gurevich.
Read: This is the most overvalued stock market on record — even worse than 1929
“The only thing extreme PE ratios can tell us is that there is a higher chance that markets would underperform over the following 5-10 years,” he said.
James Abate, chief investment officer at Centre Asset Management, said high valuations do not precipitate a correction, but drawdowns at the time of high PEs are substantial.
“We have all the conditions for a major drawdown — extreme PE, all-time profit margins, as well as a late-stage economic cycle. We just don’t know what will trigger a selloff or when,” said Abate.
Technical patterns and price action
Watching technical patterns, particularly when they form trends, is another favorite of financial gurus to try to predict major selloffs.
Sandy Jadeja, chief market strategist at Master Trading Strategies, for example, is predicting a 30% plunge in the Dow as soon as this week, based on a timeline pattern.
Most technical indicators are based on price action patterns, or trends, that require humans to recognize them. The dynamic nature of markets and increased competition from computer-generated trading using advanced algorithms are making it harder to profit from market trends.
Mike Harris, a quant trader and author of books on technical trends, said there are some indicators that work better in pinpointing tops and bottoms, but most lose their significance due to the crowding effect.
“Market timing is not a myth. It is possible, but due to the non-stationary nature of financial price series, the indicators that pinpoint tops and bottoms constantly change, i.e., a good indicator 10 years ago is no longer working and an indicator that did not work then is now working better,” he said.
“One problem with trend following is that its execution requires a model, unless one is a passive investor, and then things are simpler. But a model is an approximation of reality. Markets always try to defeat models,” Harris said.
Lance Roberts, chief investment strategist at Clarity Financial, LLC, who manages portfolios for clients, relies on three indicators to cut back his risk and avoid losses during corrections.
“My primary indicator is the moving average convergence/divergence oscillator (MACD), based on weekly data. But it needs to be confirmed by monthly average crossovers of the short- and long-term trends. We use these to reduce or increase risk and never to be all in or all out,” said Roberts.
Roberts concedes that no indicator to buy or sell based on a model is foolproof and there are times he’s been wrong.
“In 2011, around the debt ceiling issue, we acted on our signals but stayed out of the market longer than we should have,” Roberts said. The SP 500
fell nearly 19% from peak to trough between April and October in 2011 when the Republican and Democratic lawmakers fought over lifting the debt ceiling, which threatened a government shutdown.
“We use fundamental analysis to decide what we buy, and use technical analysis to decide when to buy or how to allocate assets in our portfolio. [The latter is] primarily a risk management tool,” he said.
Gurevich adheres to a very specific non-market-timing rule: “I hold an asset either until I hit my price target or for a specific time, betting on the trend direction, but never both at the same time.”
“If you want to be a successful investor, you should forget about your gut feeling, hunches, intuition or somebody’s else’s opinion about what the market will do, because that will be worth zero,” Gurevich said. “The only sensible way to invest for individual investors is to have a balanced portfolio that rebalances mechanically.”