Market timing
Encyclopedia
Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical
or fundamental
analysis. This is an investment strategy
based on the outlook for an aggregate market, rather than for a particular financial asset.
based on pure chance
because they do not believe in undervalued or overvalued markets. The efficient-market hypothesis claims that financial prices always exhibit random walk
behavior and thus cannot be predicted with consistency.
Some consider market timing to be sensible in certain situations, such as an apparent bubble
. However, because the economy is a complex system
that contains many factors, even at times of significant market optimism or pessimism, it remains difficult, if not impossible, to pre-determine the local maximum or minimum
of future prices with any precision; a so-called bubble can last for many years before prices collapse. Likewise, a crash
can persist for extended periods; stocks that appear to be "cheap" at a glance can often become much cheaper afterwards before either rebounding at some time in the future or heading toward bankruptcy
.
Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka, mutual fund
s. Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a buy-and-hold
strategy with periodic "rebalancing".
s, many of these same brokerages take the opposite approach with their large institutional clients, trading various financial instruments for these clients in an attempt to "predict future market price movements" and thereby make a profit for the institutions. This dichotomy in the treatment of institutional vs. retail clients can potentially be controversial for the brokerages. It may suggest for example that retail brokers and their clients are discouraged from market timing, not because it doesn't work, but because it
would interfere with the brokerages' market maker trading for their institutional clients. In other words, retail clients are encouraged to buy and hold
so as to maintain market liquidity
for the institutional trading. If true, this would suggest a conflict of interest, in which the brokerages are willing to sacrifice potential returns for the smaller retail clients in order to benefit larger institutional clients.
The 2008 decline in the markets is instructive. While many retail brokers were instructed by their brokerages to tell their clients not to sell, but instead "look to the long term", the market makers at those same brokerages were busy selling to cash to avoid losses for the brokerages' large institutional clients. The result was that the retail clients were left with huge losses while the institutions fled to the safety of short term bonds and money market funds, thereby avoiding similar losses.
. This means that a given set of trading rules has been over-optimized to fit the particular dataset for which it has been back-tested. Unfortunately, if the trading rules are over-optimized they often fail to work on future data. Market timers attempt to avoid these difficulties in a number of ways. One is by looking for clusters of parameter values which work particularly well. Another is using out-of-sample data, which ostensibly allows the market timer to see how the system will work on unforeseen data. However, critics charge that once the strategy has been revised to reflect such data it is no longer "out-of-sample".
' Renaissance Technologies Medallion Hedge Fund has consistently outperformed the market. The fund allegedly uses mathematical models developed by Elwyn Berlekamp.
A recent study suggested that the best predictor of a fund's consistent outperformance of the market was low expenses and low turnover, not pursuit of a value or contrarian strategy. However, other studies have concluded that some simple strategies will outperform the overall market. One market-timing strategy is referred to as Time Zone Arbitrage.
in 2003 where some mutual fund
s "secretly" allowed select investors to rapidly trade the portfolio despite statements banning the practice in the prospectus. The scandal did not involve market timing per se, and market timing is not itself illegal. The scandal involved permitting selected investors to make frequent and repeated trades during the day while permitting general investors to trade only at the close of business, which permitted the favored investors to take advantage of market-timing strategies. "A double standard that favors one investor at the expense of another is illegal and undermines the credibility of the industry." In this instance, the market timing frequently involved predictions of the performance of how international markets would respond to the day's trading in the US. This scandal
also involved late trading
.
Although the illegal activities of this scandal had nothing to do with legitimate market timing, some in the brokerage and mutual fund industries have nevertheless attempted to link the two. While the motives for doing this remain unclear, one view is that doing so is consistent with the industries' long held view that retail investors should avoid trading and instead buy and hold.
and TrimTabs
. These show that flows generally track the overall level of the market. For example, in the beginning of the 2000s decade, the largest inflows to stock mutual funds were in early 2000 while the largest outflows were in mid 2002. It is good to note that these mutual fund flows were near the start of a significant bear (downtrending) market and bull (uptrending) market respectively. A similar pattern is repeated near the end of the decade.
This mutual fund flow data seems to indicate that most investors (despite what they may say) actually follow a buy high, sell low strategy. Studies confirm that the general tendency of investors is to buy after a stock or mutual fund price has already increased. This creates a surge in the number of buyers which then drives the price even higher. However, eventually, the supply of buyers becomes exhausted, and the demand (supply and demand
) for the stock declines and the stock or fund price also declines.
The famous Dalbar study found that the average investor's return in stocks is much less than the amount that would have been obtained by simply holding an index fund consisting of all stocks contained in the S&P 500
index.
A recent study suggests that corporations and investment banks cannot time the credit markets. They show that investment banks such as Goldman Sachs do as poorly as firms like Ford when it comes to timing the issuance of their bonds.
has long frowned on the practice since it passes the trading costs to long-term investors. Consequently, many brokerages will not fill market-timing orders.
when markets are high and more risk averse when markets are low. This is consistent with recency bias and seems contrary to the acrophobia
explanation. "The only problem is that, unlike Mr. Spock
of Star Trek
fame, humans are not entirely rational beings."
Proponents of the efficient-market hypothesis claim that prices reflect all available information. EMH assumes that investors are highly intelligent and perfectly rational. However, others dispute this assumption. "Of course, we know stocks don't work that way." In particular, proponents of behavioral finance
claim that investors are irrational but their biases are consistent and predictable.
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
or fundamental
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
analysis. This is an investment strategy
Investment strategy
In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...
based on the outlook for an aggregate market, rather than for a particular financial asset.
Moving average
Market timing often looks at various moving averages. Popular are the 50- and 200-day moving averages. Some people consider that if the market has gone above the 50- or 200-day average that should be considered bullish, or below conversely bearish. Some consider it significant when one moving average crosses over another. The market timers then predict that the trend will, more likely than not, continue in the future. Others say, "nobody knows", and that world economies and stock markets are of such complexity that market timing strategies are unlikely to be more profitable than buy-and-hold strategies.Differing views on the viability of market timing
Whether market timing is ever a viable investment strategy is controversial. Some may consider market timing to be a form of gamblingGambling
Gambling is the wagering of money or something of material value on an event with an uncertain outcome with the primary intent of winning additional money and/or material goods...
based on pure chance
Randomness
Randomness has somewhat differing meanings as used in various fields. It also has common meanings which are connected to the notion of predictability of events....
because they do not believe in undervalued or overvalued markets. The efficient-market hypothesis claims that financial prices always exhibit random walk
Random walk
A random walk, sometimes denoted RW, is a mathematical formalisation of a trajectory that consists of taking successive random steps. For example, the path traced by a molecule as it travels in a liquid or a gas, the search path of a foraging animal, the price of a fluctuating stock and the...
behavior and thus cannot be predicted with consistency.
Some consider market timing to be sensible in certain situations, such as an apparent bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
. However, because the economy is a complex system
Complex system
A complex system is a system composed of interconnected parts that as a whole exhibit one or more properties not obvious from the properties of the individual parts....
that contains many factors, even at times of significant market optimism or pessimism, it remains difficult, if not impossible, to pre-determine the local maximum or minimum
Maxima and minima
In mathematics, the maximum and minimum of a function, known collectively as extrema , are the largest and smallest value that the function takes at a point either within a given neighborhood or on the function domain in its entirety .More generally, the...
of future prices with any precision; a so-called bubble can last for many years before prices collapse. Likewise, a crash
Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...
can persist for extended periods; stocks that appear to be "cheap" at a glance can often become much cheaper afterwards before either rebounding at some time in the future or heading toward bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
.
Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka, mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s. Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a buy-and-hold
Buy and hold
Buy and hold is a long-term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short-term market timing, i.e...
strategy with periodic "rebalancing".
Brokerages may favor institutional investors at the expense of smaller retail investors
Perhaps consistent with these two opposing views is that, as with any type of trading, market timing is difficult to carry out on a consistent basis, particularly for the individual investor unschooled in technical analysis. Retail brokers are also generally unschooled in both the mind set and the tools needed to successfully time the market, and indeed most are actively discouraged by the brokerages themselves from moving their clients in and out of the market. However, as market makerMarket maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s, many of these same brokerages take the opposite approach with their large institutional clients, trading various financial instruments for these clients in an attempt to "predict future market price movements" and thereby make a profit for the institutions. This dichotomy in the treatment of institutional vs. retail clients can potentially be controversial for the brokerages. It may suggest for example that retail brokers and their clients are discouraged from market timing, not because it doesn't work, but because it
would interfere with the brokerages' market maker trading for their institutional clients. In other words, retail clients are encouraged to buy and hold
Buy and hold
Buy and hold is a long-term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short-term market timing, i.e...
so as to maintain market liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
for the institutional trading. If true, this would suggest a conflict of interest, in which the brokerages are willing to sacrifice potential returns for the smaller retail clients in order to benefit larger institutional clients.
The 2008 decline in the markets is instructive. While many retail brokers were instructed by their brokerages to tell their clients not to sell, but instead "look to the long term", the market makers at those same brokerages were busy selling to cash to avoid losses for the brokerages' large institutional clients. The result was that the retail clients were left with huge losses while the institutions fled to the safety of short term bonds and money market funds, thereby avoiding similar losses.
Curve fitting and over-optimization
A major stumbling block for many market timers is the phenomenon of curve fittingCurve fitting
Curve fitting is the process of constructing a curve, or mathematical function, that has the best fit to a series of data points, possibly subject to constraints. Curve fitting can involve either interpolation, where an exact fit to the data is required, or smoothing, in which a "smooth" function...
. This means that a given set of trading rules has been over-optimized to fit the particular dataset for which it has been back-tested. Unfortunately, if the trading rules are over-optimized they often fail to work on future data. Market timers attempt to avoid these difficulties in a number of ways. One is by looking for clusters of parameter values which work particularly well. Another is using out-of-sample data, which ostensibly allows the market timer to see how the system will work on unforeseen data. However, critics charge that once the strategy has been revised to reflect such data it is no longer "out-of-sample".
Independent review of market-timing services
Several independent organizations (e.g., Timer Digest and Hulbert Financial Digest) have tracked some market timers' performance for over thirty years. These organizations have found that purported market timers in many cases do no better than chance, or even worse. However, there are exceptions, with some market timers over the thirty year period having performances that substantially and reliably exceed those of the general stock market or the sectors in which that the market timers invest. Jim SimonsJames Harris Simons
James Harris "Jim" Simons is an American hedge fund manager, mathematician, and philanthropist.In 1982, Simons founded Renaissance Technologies, a private investment firm based in New York with over $15 billion under management; Simons is still at the helm, as CEO, of what is now one of the...
' Renaissance Technologies Medallion Hedge Fund has consistently outperformed the market. The fund allegedly uses mathematical models developed by Elwyn Berlekamp.
A recent study suggested that the best predictor of a fund's consistent outperformance of the market was low expenses and low turnover, not pursuit of a value or contrarian strategy. However, other studies have concluded that some simple strategies will outperform the overall market. One market-timing strategy is referred to as Time Zone Arbitrage.
Scandal wrongly tainting legitimate market timing
A scandal erupted in the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
in 2003 where some mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s "secretly" allowed select investors to rapidly trade the portfolio despite statements banning the practice in the prospectus. The scandal did not involve market timing per se, and market timing is not itself illegal. The scandal involved permitting selected investors to make frequent and repeated trades during the day while permitting general investors to trade only at the close of business, which permitted the favored investors to take advantage of market-timing strategies. "A double standard that favors one investor at the expense of another is illegal and undermines the credibility of the industry." In this instance, the market timing frequently involved predictions of the performance of how international markets would respond to the day's trading in the US. This scandal
also involved late trading
Late trading
Late trading is trading executed after the standard local national exchanges have closed. This is distinct from after-hours trading, as they have in context specific meanings, the former may be illegal while the latter is legal.-Mutual funds:...
.
Although the illegal activities of this scandal had nothing to do with legitimate market timing, some in the brokerage and mutual fund industries have nevertheless attempted to link the two. While the motives for doing this remain unclear, one view is that doing so is consistent with the industries' long held view that retail investors should avoid trading and instead buy and hold.
Evidence against market timing
Mutual fund flows are published by organizations such as Investment Company InstituteInvestment Company Institute
The Investment Company Institute is the national association of U.S. investment companies. ICI encourages adherence to high ethical standards, promotes public understanding of funds and investing, and advances the interests of investment funds and their shareholders, directors, and advisers.As of...
and TrimTabs
TrimTabs Investment Research
TrimTabs Investment Research, Inc. is an independent investment research firm based in Sausalito, California.-Business Description:TrimTabs is an independent research service that publishes detailed daily coverage of global stock market liquidity--including mutual fund and exchange-traded fund...
. These show that flows generally track the overall level of the market. For example, in the beginning of the 2000s decade, the largest inflows to stock mutual funds were in early 2000 while the largest outflows were in mid 2002. It is good to note that these mutual fund flows were near the start of a significant bear (downtrending) market and bull (uptrending) market respectively. A similar pattern is repeated near the end of the decade.
This mutual fund flow data seems to indicate that most investors (despite what they may say) actually follow a buy high, sell low strategy. Studies confirm that the general tendency of investors is to buy after a stock or mutual fund price has already increased. This creates a surge in the number of buyers which then drives the price even higher. However, eventually, the supply of buyers becomes exhausted, and the demand (supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
) for the stock declines and the stock or fund price also declines.
The famous Dalbar study found that the average investor's return in stocks is much less than the amount that would have been obtained by simply holding an index fund consisting of all stocks contained in the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
index.
A recent study suggests that corporations and investment banks cannot time the credit markets. They show that investment banks such as Goldman Sachs do as poorly as firms like Ford when it comes to timing the issuance of their bonds.
Legality
While market timing is legal, the Financial Industry Regulatory AuthorityFinancial Industry Regulatory Authority
In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization . FINRA is the successor to the National Association of Securities Dealers, Inc. ...
has long frowned on the practice since it passes the trading costs to long-term investors. Consequently, many brokerages will not fill market-timing orders.
What some financial advisors say
Financial advisors often agree that investors have poor timing, becoming less risk averseRisk aversion
Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....
when markets are high and more risk averse when markets are low. This is consistent with recency bias and seems contrary to the acrophobia
Acrophobia
Acrophobia is an extreme or irrational fear of heights. It belongs to a category of specific phobias, called space and motion discomfort that share both similar etiology and options for treatment.Most people experience a degree of natural fear when exposed to heights, especially if there is little...
explanation. "The only problem is that, unlike Mr. Spock
Spock
Spock is a fictional character in the Star Trek media franchise. First portrayed by Leonard Nimoy in the original Star Trek series, Spock also appears in the animated Star Trek series, two episodes of Star Trek: The Next Generation, seven of the Star Trek feature films, and numerous Star Trek...
of Star Trek
Star Trek
Star Trek is an American science fiction entertainment franchise created by Gene Roddenberry. The core of Star Trek is its six television series: The Original Series, The Animated Series, The Next Generation, Deep Space Nine, Voyager, and Enterprise...
fame, humans are not entirely rational beings."
Proponents of the efficient-market hypothesis claim that prices reflect all available information. EMH assumes that investors are highly intelligent and perfectly rational. However, others dispute this assumption. "Of course, we know stocks don't work that way." In particular, proponents of behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
claim that investors are irrational but their biases are consistent and predictable.
See also
- Stock market cyclesStock market cyclesStock market cycles are the long-term price patterns of the stock market.-Description:There are many types of business cycles including those that impact the stock market....
- Market trendMarket trendA market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...
- Asset allocationAsset allocationAsset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
- Stock market forecasting