Can you forecast the market?
Market timing isn't for everyone. But there are lessons to learn from professionals putting up impressive numbers - and challenging conventional wisdom.
Forget for a moment all conventional wisdom about investing - all the "expert" advice, mutual-fund newsletters, and so on - and consider this question: Can investors successfully "time" the market, buying and selling at appropriate points to boost their returns and reduce their risk?
Most financial advisers say it's almost impossible - and certainly beyond the reach of the average investor. But a small group of professionals is challenging that notion by outperforming the market, including one investment adviser who practices what he calls "climate investing."
It's an intriguing idea. You adjust your portfolio to the market climate in much the same way you change your wardrobe to fit the season. You still can't predict next week's close, the adviser says. But if it's wintertime in stocks, you're more likely to need a wool coat than a T-shirt. His long-term outlook: Grab that coat. There's a chill in the air.
"Stocks are not cheap here and therefore are likely to deliver below-average long-term returns," says John Hussman, chief practitioner of climate investing and manager of the Hussman Strategic Growth Fund and the Hussman Total Return Fund (www.hussman.net). His strategic growth fund ranks No. 1 in three-year performance (out of more than 5,500 diversified domestic funds) when measured by the Sharpe ratio. The ratio gauges return according to the risk taken to achieve the return.
Hussman believes investors should trim their exposure to stocks until the climate improves. About half his strategic growth fund is hedged in case the market declines.
Such advice runs counter to mainstream investment thinking. And there are good reasons for skepticism. But the best strategists and market timers are worth heeding because they challenge the heart of conventional market theory.
Conventional wisdom holds that the market almost always works efficiently. In other words, stock prices move up and down because investors make rational decisions based on changes in company earnings, economic conditions, and so on. But if the market moves to extremes in ways traditional market theory can't explain, then other approaches may offer more profit and less risk.
According to Hussman, keeping the market efficient is like trying to make a hyperactive sheep stand on a nickel. You might succeed for a while, "if you have a lot of sheepdogs that are hungry and inspired and willing to correct every deviation. But if the sheepdogs ever begin to believe that the sheep will stay on the nickel by itself, then that sheep may not even remain in the neighborhood."
Frequently, it seems, investors don't make good watchdogs. Instead of refusing to buy unless values are reasonable, they tend to buy stocks "as though they were buying lottery tickets or betting on a horse race," Hussman says. "What distinguishes a [true] investor from a speculator is an investor asks: 'Where is the value? And what is the price?' "
That's true enough, skeptics say, but as a group, market timers haven't performed very well. Indeed, some studies suggest the majority of fund managers even fail to match market indexes. That's why index funds, which simply try to match the Standard & Poor's 500 or some other index, often do as well or better than actively managed funds.
By contrast, Hussman's strategic-growth fund is up 65 percent since its inception in July 2000 through a carefully constructed mix of value investing, hedging, and timing strategies. Remarkably, its largest decline from peak to trough has been about 7 percent. By comparison, the S&P 500 is down about 25 percent during the same period, and holders of S&P 500 index funds have endured a painful peak-to-trough drawdown of about 49 percent.
While such short-term performance should be viewed cautiously, other investors have outperformed the market over the long term. Among those who have enjoyed extraordinary long-term success by incorporating elements of short-term or long-term timing into their investing across many markets are John Henry, owner of the Boston Red Sox; William O'Neil, publisher of Investor's Business Daily; Marty Schwartz, who ran $40,000 to about $20 million with never more than a 3 percent drawdown; and Ed Seykota, the Massachusetts Institute of Technology engineer and investment luminary from Lake Tahoe, Nev.
Are they merely the exceptions who prove the rule? Interestingly, some of the traders who have performed well have taught students who have also outperformed the market. The Turtles, a group taught by commodity traders Richard Dennis and William Eckhardt, are perhaps the best-known group of highly successful students in the trading world.
OK, some analysts say, maybe a few gifted individuals can beat the market, but average investors can't. People are better off allocating their portfolio among stocks, bonds, and other investments, they conclude, rather than moving in and out of stocks. And how much they put into stocks should depend on how much risk they care to take on.
"We might address the level of market risk by recommending a lower allocation to equities and perhaps a higher allocation to bonds and cash," says Catherine Gordon of Vanguard Group, an investment management company based in Valley Forge, Pa. But risk exposure "is something that should be driven by the client's objectives and needs and not by an external timing model."
By definition, allocating assets reduces the overall level of market risk. That's an important technique for any investor. Its limitation is that it doesn't decrease the risk for the stock portion of someone's portfolio. In the Vanguard model, as long as a client's objectives and needs remain the same, her exposure to market risk remains the same, no matter where the market stands.
In contrast, a central tenet of the timers' approach is that there are times to reduce exposure to stock and times to jump in with both feet.
History urges caution at the moment, many timers suggest. Prior to 2000, the market peaked in 1929, 1972, and 1987 then crashed each time (see chart). At those peaks, the broad market reached values of about 20 times peak earnings. In other words, an investor wanting to buy a company's stock had to pay about $20 for every $1 that company earned in a year. (To account for recessions, when earnings fall quickly, Hussman uses the highest earnings achieved in the prior decade, something that can be called peak earnings.) Now, despite its huge fall since 2000, the market stands at 19.5 times peak earnings.
"When stocks have been as richly valued as they are now, there's always been some period between four and 17 years later when stocks have reached a durably low valuation," Hussman says. During that time, "the returns have been dismal."
In the shorter term, some analysts are bullish. "Improving economics, better profits, risk-averse investors, global expansion, and election-year rhetoric should push the market higher," says Ned Riley, chief investment strategist at State Street Global Advisors.
In running his fund's portfolio, Hussman takes the shorter term into account by adjusting the market risk of the portfolio according to his statistical assessment of the current market climate. He defines market climate as a combination of market levels and shorter-term conditions including interest-rate trends, how broadly the market is rising or falling, and other factors.
As for average investors, Hussman discourages active market timing but does suggest they add to their stock holdings when the market is cheap and trim holdings when it's expensive.