July 29th, 2009

Market Timing More Important Than Stock Selection

No matter which way you look at it, this market is “trendless”. If you’re a short-term trader, then you know that the market today is about where it was at the beginning of June. An intermediate-term trader, knows that the market is where it was last October and has been forming that inverted head-and-shoulder pattern (note: H+S patterns are reversal patterns at bottoms or tops but rarely consolidation patterns within a trend). And if you’re a long-term trader then you know that the market is almost exactly where it was in 2002-03 and far below the highs of 2000 and 2007.

Furthermore, I hope you now believe that there’s about a 70% probability that stocks move in sync with the market. If the market trends up, stocks you own will also likely move up; the only thing you don’t know is whether it will be a greater or lesser percentage move. Conversely, if the market trends down, it’s nearly impossible to find a stock that moves against that decline. That’s why you don’t have to be a genius to make money in up markets and, in down markets — well, you’ve heard the saying, “the winner is the one who loses the least.”

I think the past 24 months has proven that diversification is a false promise. It didn’t matter whether you were diversified across industries, across growth or value, across US and international stocks – the only thing that could have protected your portfolio was moving into cash.

So what should your portfolio strategy be in any market, especially those that are “trendless” corrections? Mine, in a nutshell, is:

  1. Measure the portfolio’s performance relative to a benchmark (mine is the S&P 500 but any will do so long as it’s applied consistently) every day and keep an on-going, graphic record of that daily performance (mine goes back to 2002 relative to the S&P 500).
  2. It’s more important to decide how much I want to put at risk (100%, 60%, 35% or 0% invested in stocks) than how many and which specific stocks the money is in.
  3. When the market is trending up, aim to have as much of the money invested in stocks having a high volatility. In that sense, it more important to have 40% invested in stocks that will likely appreciate twice as fast as the market than it is to have 80% invested in stocks that appreciate less than the market.
  4. When the market is trending down, take steps to reduce risk and exposure by:
    • Selling portions of the positions that have had the largest percentage gains (selling the whole position might cause you to lose track of some potential long-term “triple baggers”)
    • Sell recent additions; in all likelihood there won’t be any opportunity cost in doing so.
    • Hedge the remaining exposure by purchasing either puts on the SPY or purchasing a short Index ETF’s (if your portfolio moves the same percentage as the S&P, each $1 in a double short will hedge $2 of the portfolio).
    • Things are different today from they’ve ever been with the introduction of nearly half as many ETFs and ADR’s as there are domestic stocks. When appropriate, diversify the exposure by shifting portions into commodity, foreign exchange, foreign market and debt ETFs (both long and short).

I have some great stocks right now, many of which I’ve listed here and some that I haven’t shared with you yet. As a matter of fact, they all have or are on the verge of having broken out of reversal patterns or crossing above some significant resistance (either trendline or moving average). But in what I believe will be a frustrating market for the next several weeks, you earn no points and clearly will have a hard time making any money by trying to find stocks that go up as the market moves aimlessly or actually declines. You only continue to add to the performance relative to your benchmark by reducing your risk exposure.

I’ve written about the “traders’ remorse” correction I see coming over the balance of the summer and I’ve decided to act in response to that belief on my own portfolio. I don’t invest in stocks; I put money at risk to earn a return. I don’t get married to my positions because there’s no way to tell which stocks and which industries will lead when the correction ends. It’s been at around 65% invested and I look forward to the day soon when I will feel comfortable enough to be “all-in”. But, given that potential market correction, I’ve started employing some of the strategies described above.

One final point: Tax considerations is always given as an arguments against employing market timing strategies. “You want to hold your stocks so you can get long-term capital gains treatment, don’t you?” Well, not really, because most investors now have a large percentage of their invested money in tax deferred retirement accounts where the only consideration is growing and preserving the money; holding period is irrelevant.

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  • Anonymous

    Do you knows sources for tracking high yield spread? thx!

  • Jim

    An excellent article, thanks.

  • harry

    Hi I regularly read your blogs and find them very helpful – thanks!

    I have a little generic question: for some time now (if I didn't miss it), you didn't talk about your "Market Timing Indicator". What does your indicator tell you nowadays?

  • Guru

    I did a search on the term "high yield spreads" and found this item that includes several graphs you might find of interest: http://tinyurl.com/hi-yield-spreads

  • Guru

    I haven't mentioned the MTI recently because it gave an all-clear signal on June 1, 42 trading days ago, when the S&P 500 was at 942. My quandary is that even though I increased my invested positions to 65%, I wasn't willing to go to 100% until there was a clear break above the inverted h+s neckline.

    Even though the cross over happened it wasn't with sufficient conviction so now I'm waiting for the test of the support at the neckline.

    It's a judgment call on my part in contradiction to historical precedent.

  • harry

    Thanks, that clarifies it a lot! 🙂

  • Z

    Thanks for the blog updates.
    Another indicator I have been watching is the cross of the 20 and 50 week simple moving averages on the SPX. I have not used this method but I'd like to hear your thoughts on it. This system would have had you in cash from Jan. 2008 and likely would have you re-invest next week should they cross.

  • Guru

    Z, your 20- and 50- week cross indicator is almost the same as a the-100 day crossing above the 250-day when each week equals 5 trading days. It's also not much different than what's conventionally called a "golden cross", the 100-day crossing the 200-day (or, what I original worked with, the 90-day cross above the 180-day, but have switched to the more conventional MA's when I found they're so close).

    The point is that nearly any two longer-term MA's you select will produce a fairly good "bimodal" indicator (all in or out). You get whipsawed only when you select shorter terms, like 20- and 50-day; those are more appropriate for day-traders.