Market Timing, Tactical Asset Allocation, and Trading: A Dialogue

Here’s a dialogue between two sides of myself: Moses, who’s a proponent of market timing and tactical asset allocation (TAA), and Celeste, who thinks it’s bunk.

Moses: What is the difference between trading, tactical asset allocation, and market timing? In all three cases you’re buying and selling assets that are designed to be held for far longer than the amount of time you’re holding them.

I’m a stock picker. I very rarely hold stocks longer than nine months. I place buy and sell orders every week, sometimes every day. I’ve been able to consistently beat the market, with a CAGR of over 40% for more than three years, by using a ranking system on Portfolio123 to invest in microcaps.

Now if I were to do exactly the same thing with a limited number of ETFs, buying and selling them at different times, I would be doing TAA instead of trading. And if I were to limit myself to just two ETFs, SPY (which tracks the S&P 500) and ICSH (which tracks short-term government bonds), I’d be doing market timing.

So my gut tells me that all those pundits who say that buy-and-hold always beats market timing are the same pundits who say that index funds always beat stock-picking. And if they’re wrong about the latter, why shouldn’t they be wrong about the former?

Celeste: People have been trying to do market timing for over a hundred years and nobody yet has gotten it right. If someone were to get it right, beautifully timing her entrances and exits so as to altogether miss every correction and every bear market but capture entirely every major upswing, she would basically rule the world. Why? Because enough people would follow her lead that she’d be able to effectively manipulate the entire stock market and make more money than anyone in history.

Let’s say she times the market impeccably for twenty-five years, becoming famous in the process. Let’s say that 75% of the investment world doesn’t believe her predictions despite her amazing success, but 25% does.

Now let’s say that she predicts that the stock market will take a downturn sometime in the next few weeks. 25% of investors will sell all their stocks, resulting in a massive downturn. Several months later, she predicts that the downturn is over, and that stocks will shortly stage a massive recovery. 25% of investors will promptly buy stocks, sending the market soaring again.

In other words, the more successful a market timer is, the more impact she will have on actual stock prices, making her prophecies self-fulfilling.

This conclusion won’t have escaped her. She will very quickly realize that she can sell her own personal holdings, then predict a stock market downturn. Stock prices will tumble. She can then buy up huge quantities of stock and predict an upturn. Stock prices will soar, and she’ll make a tidy profit. The more often she makes her predictions, the richer she will get.

What would happen then? The entire stock market would collapse. Nobody wants to buy into a rigged system.

This logically leads to the following conclusion, as a kind of axiom. The appeal of the stock market rests on its unpredictability. If the stock market were predictable, someone could game it, and every other participant in it would feel like they were being taken for a ride. Nobody wants to invest in something that someone else can game.

Moses: That’s not true at all. It’s pretty clear to everyone that the lottery is gamed in favor of the ticket-sellers, sports betting is gamed in favor of the bookie, slot machines are gamed in favor of the casino, and there’s always a house take in a poker game. Similarly, the stock market is gamed in favor of the market makers, who profit from the bid-ask spread. So there is room for a successful market timer in the mix. Good market timers don’t get everything perfectly right. But they can beat buy-and-hold investors, with less risk, and they typically keep their methods to themselves.

Celeste: The Nobel Prize–winning economist William Sharpe calculated that a market timer would have to be correct 74% of the time to beat a buy-and-hold investor. That’s a pretty tall order, especially when most pundits are right less than half the time.

There are plenty of investors who were devoted to market timing at one point and then realized the error of their ways. Take Paul Merriman, founder of Merriman Wealth Management, for example. His first book, published in 1985, two years after he’d launched the company, was called Market Timing with No-Load Mutual Funds: Low-Risk High-Return Investing with No Commissions. He has changed his tune completely. In 2013, he wrote, in an article entitled "Why Market Timing Doesn't Work," “Nearly half a century of working with investors has taught me this: Many people who try buy and hold succeed, while most of those who try timing (particularly those who do it themselves) fail.” He maintains that it’s impossible to beat the market with market timing, though it’s still useful for limiting losses. In essence, for Merriman, market timing is a way to smooth out his returns.

Moses: Merriman’s timing systems are all based on trend-following. There are many other ways to do market timing. The website Philosophical Economics has outlined some great strategies ("Growth and Trend: A Simple, Powerful Technique for Timing the Stock Market" and "In Search of the Perfect Recession Indicator") that combine trend-following with economic signals. One smart subscription-based website that offers a wide range of timing strategies is imarketsignals.com. Using some of those strategies may well help you smooth out your returns and reduce your drawdowns.

Celeste: Will they actually beat the returns of a buy-and-hold strategy? I think that’s doubtful.

Index Fund Advisors has published an extraordinarily forceful warning against market timing. You’ll read there that CXO Advisory Group tracked market-timing gurus over the 2000–2012 period, and not a single one beat Sharpe’s 74% threshold. Another study tracked 15,000 predictions made by 237 market-timing newsletters from 1980 to 1992. By the end of the period, 94.5% of the newsletters had gone out of business. John Bogle said that over a 55-year period he had never met anyone who knew how to “get out of stocks at the high and jump back in at the low,” and had never even met anyone who knew someone else who could do that.

Moses: Index Fund Advisors also makes an extraordinarily forceful warning that you can’t beat an index fund by wisely choosing stocks. And you and I both know that that’s wrong.

Market timing is just a simplified version of a much better strategy: tactical asset allocation. AllocateSmartly is a terrific subscription-based website that offers a large number of different strategies, all based on academic research and thoroughly backtested, to switch into and out of different index-based ETFs. One of the things I like best about this service is the way they’ve extended ETF data back fifty years to the days long before ETFs. I have little doubt that adopting some of these strategies will provide a smoother ride than a simple index fund.

Celeste: It’s hard for me to have much faith in any of these strategies as a long-term proposition. Charlotte Moore, a British business writer, has written a wide-ranging article that outlines the challenges that TAA strategies face. Her critique of TAA can be broken down into three main flaws:

• First, assessing where we are in the business cycle in real time can be challenging, to say the least, mainly because economic data is always lagging real-time developments and because different sets of economic data usually contradict each other or are inconclusive when looked at as a whole.
• Second, markets move much more rapidly than economic data. As Alfred Kassam, the head of equity applied research at MSCI, observes, “It is very hard to predict fast-moving financial markets using slow-moving economic data.”
• Third, the purpose of investing in alternative indexes is to beat the market over the long run, and switching in and out of them defeats that purpose altogether. If you’re buying value stocks because of the value premium, you deny yourself that premium if you switch in and out of that strategy.

Moses: This brings us back to the question that this article started with. In trading microcap stocks, I’m also buying and selling assets that were designed to be held onto for years, and doing so has made me a pile of money. If I were to practice TAA, I’d be doing the same thing; and if I were to limit my TAA to two ETFs, I’d be engaging in market timing. What’s the big difference?

Celeste: The difference, I believe, is in the nature of the assets themselves.

To successfully and consistently beat the market, you have to game the system, and in order to game the system, you can’t trade what everyone else is trading. You have to find rare opportunities—“mispriced” assets—and capitalize on them quickly. When you’re dealing with microcaps, such opportunities are legion; when you’re dealing with established indexes, those opportunities are far rarer.

Moses: Well, in most of my accounts, I can find those rare opportunities and capitalize on them. But in my family’s 401K accounts, I have very limited options and can’t invest in individual stocks. In those accounts, wouldn’t it be better for me to exit the market before a downturn and go back in when the recession is over? After all, the folks at iMarketSignals and Allocate Smartly have invested years of research into their particular strengths, and Philosophical Economics makes a very convincing case for using his/her market timer.

Celeste: Using market timing and TAA wisely may smooth your returns; you might, if you work hard enough and/or get lucky, even have a slight edge over buy-and-hold. But you might utterly fail. Go look at the real-time track records of some market timers on collective2.com, which tracks investors’ strategy results. They’re abysmal.

If your aim is to beat the market, I’m pretty certain that neither TAA nor market timing will do it. For that, you need to aim at much smaller targets than broad-based indices.

 

My top ten holdings right now: ARC, OSIR, CTEK, HALL, GSB, PFSW, PERI, INTT, NTWK, KTCC.

CAGR since 1/1/16: 40%.

Comments

[Andy]

Thanks for awesome blog! If I have understood right, your portfolio turnover is quite high. How high if your post tax cagr ?

[Andy]

Sorry about the typo. Should be: how high is your post tax CAGR ? Thanks a lot

[Yuval Taylor]

My assets are almost all in IRAs so they're tax free. I do have a taxable account, but I haven't paid taxes on my gains because they're offset by my losses, and if, come December, my gains exceed my losses, I'll use tax-loss harvesting to correct that.