Rules for Market Timing Success

The biggest enemy of investors is emotion. The reason most investors buy at the top of the market is euphoria and greed, and the reason they sell at the bottom is despair and fear. By committing and adhering to the following rules you can avoid making those mistakes.

Rule 1: Invest in a share fund, not individual stocks

Research shows that few stock pickers beat the market. [See John C. Bogle, The Little Book of Common Sense Investing, John Wiley & Sons, New Jersey, 2007, page 155.]  Even active retail fund managers struggle to beat the S&P accumulation index, largely because their management expenses usually range from 1.5% to 2.5% per annum.

Research shows that the S&P/ASX 200 Index outperformed two-thirds of active Australian general equity funds over the last 5 years. [See Standard and Poor’s Index Versus Active Funds Scorecard (SPIVA), 30 July 2009.]

A large diversified share portfolio carries less individual stock risk than a small concentrated portfolio where a few shares (e.g. ABC Learning, Allco Finance, Babcock and Brown, Rubicon Property Trusts, etc) going bust can sink the portfolio.

A share fund with a large diversified holding of stocks helps protect investors from individual stock risk, though not market risk. Only a reliable market timing system can do the latter.

Share funds are either listed (on the Australian stock exchange) or unlisted. They may be actively managed (by the funds manager) or passively indexed (tied to a stock exchange index such as the S&P/ASX 200).

Successful investors in a secular bear market are those who ride the share market up, but quickly alight when it falls. The most efficient and effective way to time the Australian share market is to invest in an index fund that reflects the ASX All Ordinaries or S&P/ASX 50, 200 or 300 price indices which account for the bulk of our market’s capitalization.

Unlisted Indexed Funds (UIFs) and Exchange Traded Funds (ETFs) with a focus on the Australian share market are designed to track such price indices. The Net Asset Value (NAV) of units in either of these types of funds is based on the value of the underlying portfolio of shares that the fund holds on behalf of unit holders. The NAV is typically established once a day after the market closes.

The prices of units bought or sold in UIFs are also determined after the end of each trading day and relate directly to its NAV whereas the prices of ETFs are those struck between buyer and sellers on the ASX during a trading day.

The price of units in an UIF typically has a buy/sell spread of 0% to 0.5% in relation to its NAV whereas an ETF has a spread between its bid and offer prices. The strike price of an ETF may stray from the NAV of the underlying assets (as driven by the share price index on which they are constructed) if there is an illiquid market (i.e. few buyers and sellers). While this was a problem in the first year of ETFs, it has become less so as the volume of trading in these instruments has grown.

ETFs track the NAV of their underlying assets more closely than Listed Investment Companies (LICs) whose prices tend to trade at large premiums or discounts to their NAV. LICs being active funds managers don’t attempt to replicate a stock exchange index, yet their large share portfolios mean they are not immune to general market movements.

EFTs have a unique design feature that normally keeps their market prices in line with the value of their underlying stocks. Institutional investors can ‘create’ and ‘redeem’ shares of ETFs in exchange for their underlying portfolio stocks. If the price of an ETF drifts too far above or below its actual value, professional traders will usually arbitrage the difference thereby forcing its price back into line very quickly.

Both UIFs and ETFs generally offer lower turnover and management costs than active share funds such as Unlisted Managed Funds (UMFs) and LICs that are trying to beat the indices. LICs, like ETFs, are shares that can be traded at any time the stock market is open.

UIFs require more paperwork than either ETFs or LICs to buy and sell and some take a long time to redeem unit sale proceeds. Also UIF managers do not encourage active trading in these funds because of the administrative burden involved. These attributes, especially any delays in executing transactions, reduce their appeal to investors who want to time the market.

Vanguard offers an UIF called the Index Australian Shares Fund which provides exposure to a wide range of companies listed on the Australian Stock Exchange. It is a low-cost, diversified share fund that avoids having to pay much capital gains tax by passively holding its stocks.

To buy a unit in Vanguard’s Index Australian Share Fund consult your financial adviser or fill out an application form on line or phone Vanguard for assistance. Unlike ETFs they do not attract brokerage, although if you buy them through a financial planner they may charge a commission.

In May 2009 Vanguard launched an ETF called Vanguard Australian Shares Index ETF (ASX Code VAS) which aims to replicate the S&P 300 index with quarterly income distributions, low portfolio turnover/ capital gains tax and a low cost (0.27% per annum).

Further information on Vanguard’s managed share funds and ETF products is available at www.vanguard.com.au

A year prior to that, State Street Global Advisers launched two Australian ETFs called SPDR S&P/ASX 200 (ASX Code STW) and S&P/ASX 50 (ASX Code SFY) which seek to closely track the S&P/ASX 200 and S&P 50 Indices respectively with half yearly income distributions, low portfolio churn/capital gains tax and low cost (0.29% per annum).

Further information on State Street ETF products is available at www.spdrs.com.au

Of the above products, ETFs tied to a popular Australian share index such as the S&P/ASX 50, S&P/ASX 200 or S&P/ASX 300 are well suited for market timing because they are listed shares with low management costs that can be quickly bought and sold through a broking house with which an investor has an account.

Buying and selling ETFs or LICs on the Australian securities exchange incurs brokerage fees which range between $15 and $150 for transactions under $15,000 or 0.1% to 1.0% for transactions over this amount. Brokerage will vary depending on whether orders are placed online through a discount broker or over a telephone to a full service broker. Because market timing involves multiple trades a year, only a discount broker should be used for executing transactions.

Warning: As with all investments, you should do your own verification, and decide for yourself the best way to invest in the Australian share market for timing purposes. Consult a financial planner experienced with using market timing signals if you are not sure.

Disclosure: MarketTiming’s principals use exchange traded funds such as STW, VAS and SFY for timing the Australian stock market.

Rule 2: Adopt a clear timing strategy from the outset and adhere to it

Decide which market timing strategy best suits your temperament and circumstances. Active timing appeals to investors who want to catch or avoid each significant market move of which there could be about half a dozen a year. Ultra-Conservative and Conservative timing suits those who want to limit their entry and exit from a share fund to around 1 to 3 times a year.

Conservative timers have to be prepared to ignore market moves until they are firmly established. While this may result in lost opportunities it also lessens false starts that can lose money. Back-testing shows our three strategies have produced similar annualised returns since 1 July 1984; between +9% and +11% per annum versus buy and hold's +7½%.

Conservative timing’s appeal is that it involves fewer transactions than Active timing. Yet, whether you use a Conservative or Active timing strategy the degree of risk (i.e. volatility) involved is significantly less than adopting a buy and hold strategy while the returns are better to the extent that market corrections and crashes are largely avoided.

A timing strategy removes emotion from share trading, and, as we know, emotions are the enemy of equity fund investors. Placing a reliable mechanical timing system between oneself and the share market is the best defence against being swayed by herd instinct and other powerful emotions from buying towards the top and selling towards the bottom of a cycle. Treat timing signals as a risk management tool to avoid knee jerk reactions to market movements that can result in bad decisions.

Rule 3: Execute the timing signals regardless of your own opinions

Investors being human are moved by the emotions of greed and fear rather than cold logic when it comes to investing in stocks. That’s why euphoria reigns towards the top of a market boom (when shares are overpriced) and panic ensues towards the bottom of a crash (when shares are underpriced). Herd instinct is very hard to resist without an automated mechanical market timing model to guide one’s actions in the share market.

During a share market correction investors typically hang onto their shares because they have an aversion to accepting any loss. They prefer to ‘slide the slope of hope’ believing that their shares will ultimately recover in value. If they hold individual stocks in terminal decline this might not dawn on them until it’s too late.

If they are in a highly diversified fund, most of whose stocks should survive even the worst market crash, their faith might eventually be rewarded. But unless they have nerves of steel they could panic and dump their fund when its unit price has plunged and the predominant market sentiment is gloom and doom. Buy and hold advocates underestimate this behavioral response which is very real for people with a low to modest risk tolerance.

After the market has collapsed and starts making a tentative recovery investors ‘climb the wall of worry’, fearing every setback might be the start of a new crash. Lots of so called experts reinforce this view causing people who exited the market to hesitate reentering it before they are confident the worst is over. By then the market may have recovered to such an extent that the price of buying back into their fund far exceeds that at which they sold their units.

The net loss can represent a large chunk of an investor's life savings. This can be emotionally wrenching where the impact is felt not only by themselves, but by their immediate family. A sense of guilt and shame for having followed the herd rather than holding their nerve is a common outcome.

The best antidote to complacency when a market is sliding and to hesitancy when it’s climbing is a good market timing service. Such a service signals when it's time to get out of the market and when it's time to get back in. Rather than riding an emotional roller coaster buffeted by conflicting facts and opinions, an active timer has the comfort of knowing they will catch any significant upwards movement in the market and a Conservative or Ultra-Conservative timer that they will re-enter the market as soon as a long-term trend has been clearly established.

But that means a timer must strictly execute market signals when received regardless of their own views about the direction of the market. It also means not jumping the gun by trying to anticipate when a change in signal might happen.

That requires focusing on the process of implementing the timing signals rather than worrying about their possible outcomes. When an investor shifts their attention from the process to the outcome they are likely to skip signals and get a worse result.

Only experience builds assurance in the process. An investor's confidence in market timing is only likely to be reinforced after two years or more when they can look back and appreciate the troughs they missed and the peaks they scaled.

Rule 4: Accept small losses to lock-in big market gains

No market timing system picks the exact top and bottom of each market move. Yet a well designed and tested timing model, such as that used by MarketTiming, has an inbuilt mechanism that allows profits to run, but cuts losses before they escalate seriously.

Since 1984, the largest losing streak over any month under MarketTiming’s Conservative Strategy (for example) was -6% compared with -42% for the buy and hold strategy. Under our Conservative Strategy, there were two winning (enter-exit) trades for every losing one over these years, and the average monthly win was +3.1% compared with the average loss of -1.8%. The end result was that the Conservative Strategy has produced a cumulative return of 1195% through to 30 June 2011 while that of buy and hold was 607%.

Of course back-tested results are not a guarantee of future performance. Yet as with any technical system (e.g. a motor car or an aircraft), track record is an important guide to its robustness.

MarketTiming uses its own proprietary models to generate long term and intermediate timing signals instead of short dated trading ones. Because of the longer time elapses involved in our signals they are based on firmer directional trends than those used for daily or swing (weekly) trading.

Rule 5: Stay committed and don’t quit

Market timing is not for dabblers. It requires patience and a commitment to adhere to market signals come what may. The temptation to run with the herd is very great. You must follow a signal to stay in a market rally even when influential market commentators predict the next move is down. You must heed a signal to leave the market when the same ‘experts’ predict a turnaround is imminent.

As a market timer you must shut out the noise of market opinion and put your faith in a 100% mechanised and automated timing model with a demonstrated record from back-testing (since 1984).

Rather than celebrating or cursing the outcome of each set of buy and sell signals, keep your faith in the process behind those signals which over time should give you a leading edge over buy and hold. Like the legendary contest between the hare and the tortoise, the winning factor was persistence.