Nick Dewhirst looks at the demand for market timing although it is in short supply at present
'Hold for long-term growth' is the standard advice now being given to investors in technology funds. How sound is that advice? In my opinion, it is about as sound as similar advice to hold on to Japan funds after 1990 or commodity funds after 1980.
Supporting this view is an underlying assumption that the stock market always rises in the long term, that unexpected setbacks are merely temporary interruptions and that it will just take a little longer to make the forecast profits. In truth, it just ain't so.
So deeply ingrained is this mind-set that it has taken over the very language of investment.
'Earnings visibility is poor' implies that it is normal for companies to make positive forecasts, but the truth is that they do not like what they see.
'The markets hate volatility' suggests that steady progress is natural, but the truth is that no one objected when markets were volatile on the upside.
'Asset allocation' indicates that tinkering around the edges of a portfolio is prudent, when it can be more like re-arranging deckchairs on the Titanic.
'Market timing is risky' asserts that it is right to stay fully invested at all times, when sell all, go away and play another investment game would often be far safer.
Fortunately, there is now a way to quantify such statements, by researching the use of search terms on the internet. Using Wordtracker, an online service that monitors search engines, I found this spring, there were 2.8 times as many requests for 'asset allocation' as for 'market timing.' Normally one might expect an even higher ratio as the implosion of tech stocks was leading to intense soul searching at the time.
This long-term chart of the world's largest stock market shows the extended periods during which investors in the stock market made zero returns. The white line represents the total return on the S&P Composite index, while the yellow line shows this in real terms adjusted for inflation, according to my calculations. As can be seen from the horizontal red lines, there are two extended periods within living memory when investors in the stock market made no money on balance, namely 1927-42 and 1964- 75. Adjusted for inflation, the second period extends to 1982.
It is equally true of other equity markets that there are long spells where buy-and-hold strategies are worthless. In the UK this was true for the FT All Share index 1964-75. In Germany it applied for the FAZ index from 1964 to 1982. In Japan, the Topix index is still only half the level it reached more than a decade ago. My global emerging markets index now stands at a level it first reached in 1993.
There are three good reasons to believe that another such flat period is likely to be developing for world markets
The rate of inflation is low so nominal returns should also be low. While modest increases in inflation from current record lows can be expected, a return to double digit rates hardly seems likely.
Furthermore, much of the boom in bond and stock markets over the past two decades was due to a one-off adjustment to the decline in inflation rates that has driven bond yields down and PE ratios up.
The collapse of the technology bubble is likely to have some knock-on effects on the rest of the world's economy and stock markets.
If capital gains are harder to achieve in the future, investors have just two options. The first is to take on more risk. The popularity of this approach has been shown in the growth of high yield bond funds. The danger is already visible in rising default rates, which are set to get even worse as the global recession deepens.
The second option is market timing. This has not been a popular investment approach since the seventies, but it can offer superior returns as well as reduced risks. This is possible because the stock market often experiences pronounced cyclical swings even while trending sideways.
By staying invested only during the upswings during the last flat patch, US investors could have generated gains of 42%, 62% and 69% in three cycles. Compounded together these gains would almost have quadrupled the value of a portfolio within a decade. While this is a theoretical example assuming 20/20 hindsight, had an investor only got it half right with 20/40 hindsight, his portfolio would nevertheless have doubled in value.
Market timing is also a safer option because funds are only committed to risky investments for limited periods. During the periods out of the market they can be invested safely on deposit, readily liquid to seize the next attractive entry point.
If this is so obvious, why then is it so unfashionable? I suggest the real reason lies in the way transactions in financial products take place. As long as advisers earn their living from up-front commissions, there will be a tendency towards file-and-forget strategies. Advisers have little incentive to provide on-going service and customers do not relish paying a new commission each time they get in or out of the market.
Fortunately, such structural objections can nowadays be avoided by the use of low cost switching facilities available within a growing range of financial products including life and pension funds that typically provide a range of equity and bond funds as well as a money market fund.
In a world where advisers are facing increasing difficulties generating commissions from the sale of new products, fee-based advisory services can provide a means for generating repeat revenues.
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