Is it possible to time the market?

Why do people time the market? That is, why do they enter and exit the market based on certain signals (moving averages, PE etc.)? Is it for getting better returns? Or is it for getting risk adjusted returns?

This is a poll I created in Facebook group Asan Ideas for Wealth. As expected, a majority of members believed that timing the market is for getting better returns.

In this post, I would like to answer this question with a digest of a research paper. I am not interested in individual investor experiences either in the US market or in the much younger Indian markets. Relying on those, in my insignificant opinion, is not the 'scientific' way to answer the titular questions. I am only interested in studies backed by academic rigour. If you don't agree, so be it. I can live with that.

I will not consider back-testing results from Indian market history. It is too short to be statistically significant. If you argue, that the Indian market is different from the US market, I can argue, 'then why is it all trading metrics are derived from backtesting studies of the US market!'.

The academic community is divided in its answer. For every report that says 'one can time the market', I can give you a report that says 'one cannot time the market'.

Naturally AMCs and mutual fund sales are expected to say, stick to you SIPs and do not time. Needless to say, such opinions can rejected straightaway.

It is important for the reader to understand that, even those papers which say  'timing works', only refer to superior risk adjusted return with market timing. Not superior return.

Risk adjusted return is a ratio - return per unit risk and is not the same as return. Crudely, price to earnings (PE) is analogous to risk-adjusted return which is distinctly different from the (stock/index) price.Read more: What is a risk-adjusted return

The most popular timing model paper is by M. T. Faber, “A Quantitative Approach to Tactical Asset Allocation”, Journal of Wealth Management, 9 (4), 69–79. (You can download this paper via above link). Ramesh Mangal tells me that this is is one of the most-downloaded papers from the SSRN network.

Faber uses a 10-month simple moving average (SMA) to time the market. This, for example is one of the simplest strategies he has used.

Monthly price > 10-month SMA --> Buy

Monthly price < 10-month SMA --> Sell and move to cash

When I read his paper, the most striking result was on page 28:

Appendix B breaks down the returns down by decade for the S&P 500 and the timing model. While the timing model outperforms in about half of all decades on an absolute basis, it improves risk-adjusted returns in about two-thirds of all decades and improves drawdown in all but two decades

The timing model improved return for only half the decades from the 1900s. This means, buying-and-holding outperformed the timing model in some decades and vice versa in other decades.

If I start to time the model today, I have no idea whether my strategy will fetch more returns (a common expectation) in the next 10 years. The chances are 50-50, if we go by past performance. As seen in yesterday's post, "Will long-term equity investing always be successful?", market dynamics are bound to change with time and past performance is unreliable in more ways than one.

Therefore, my key takeaway from Faber's paper is, Market timing depends on how the stock market fares in the future (bull/bear/sideways). Since I do not know how it will fare in the future, success is down to luck.

I was looking for a research work to back my thinking. When Prashanth Krishna who runs portfolio yoga tweeted about a new paper on market timing: Revisiting the Profitability of Market Timing with Moving Averages.

When I corresponded with the author of the above paper, Prof. Valeriy Zakamulin, School of Business and Law, University of Agder, Norway, he cited his other work on market timing: A Comprehensive Look at the Empirical Performance of Moving Average Trading Strategies and sent me the original figures for this post!

They considered multiple market timing strategies like simple moving average, exponential moving average, double moving average (like the hurricane warning chart in the Nifty Valuation Analyzer) using the S&P 500  from Jan 1860 to Dec 2014 (155 years, 1860 months!). They divided the data set into two using statistical means.

Market-timing-1
The dotted lines divides the S&P 500 data set into two with approximately equal number of bull and bear phases
Market-timing-2
The evolution of the S&P 500 in two two periods. The bear phases are shaded.

Their main conclusions are listed below:

1. There is  strong evidence that the stock market dynamics are changing over time.

In the second half of the data set (panel B) the stock market was less volatile, the stock prices grew with a rate that was more than double as much as that over the first half, and the ratio of the average Bull market length to the average Bear market length was almost double as much as that over the first half.

2. Moving average strategies outperformed the market in the first period (panel A).There is no statistically significant evidence of outperformance in the second period (panel B)

Thereby our findings cast doubts that market timing strategies can consistently beat the market.

3. There is optimal moving average duration. For example,many think that the 200-day DMA is the 'best' to use. This cannot be justified.

4. "The outperformance delivered by market timing strategies is highly uneven over time. Most of the outperformance is generated mainly over relatively few particular historical episodes" Results depend crucially on the sample period chosen. Which is why many authors argue in favour of timing.

If one chooses the sample period to be, for instance, either 1900-2010, 1970-2010, or 1990-2010, and simulates, for example, the SMA(10 month) strategy, then one comes to conclusion that market timing works

If the sample period chosen is 25 years after 1970, then market timing fails. If the sample period is post 2000 then market timing wins. The point is, market timing works ...sometimes. Since we do not know how the market will fare in future, is it impossible to claim market timing will work for my investment strategy!

Conclusion:

If you have reached up to this point, thank you for your patience. There is no statistically rigorous evidence that market timing will work. If wish to enter and exit  following the PE  or moving averages, I strongly suggest you keep better risk adjusted portfolio return and (temporary) capital protection as the goal and not 'higher returns'.

I am not recommending to time the market. Personally I will not time the market because it does not suit my temperament and I have better things to do.

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12 thoughts on “Is it possible to time the market?

  1. Ashish Gupta

    So I don't time the market when I invest periodically or through SIP. But unless I am investing in Index fund, I *AM* implying that *someone* can time the market (my MF Manager). Indirectly, my investments are timing the market.

    Given that you have concluded in past that Index investing doesn't work in India because of various reason (poor construction of Index, consistent out performance of an average MF over benchmark, etc.), you do agree that market timing is possible to generate superior returns.

    Do you? Where is my logic wrong?

    Reply
    1. freefincal

      That index fund does not work in India (so far) is a fact. Whatever the reasons are.
      Timing here refers to the change in asset allocation of a portfolio based on market movements. Not all funds do that and if I invest in such a fund, I am indirectly timing the market, yes. For the record, I don't.

      Reply
      1. sundararajan

        I am thinking on the same lines. How does active MF work? Assuming they don't time the market, they have to exit a stock at certain time to book the profit? Right? At the same time, they have to enter the market (buy a stock) when it is lower price? Yes everything is relative and I believe that an active fund manager looks into whole lot of things before buy/sell a stock.
        My question is, if I am paying high % as expense for the MF, isn't the responsibility of the MF manager to perform (read timing market or whatever). If one would have to time the market based on PE / moving average, why one have to invest in MF? One can invest directly in stocks by looking at the top holdings of the portfolio of one or MF funds?
        Am I missing something here?
        For sure, I am still a pre-kg student on MF itself , forget about direct stock investments. But curious to know.

        Reply
        1. freefincal

          Buying a stock at right price and selling it for the right amount of profit is NOT timing the market.

          Reply
        2. Anjan

          The basic problem is that equity funds have to invest atleast 65% in equities to be eligible for the equity tag and hence LTCG benefits after 1 year. So the fund manager tries to do his best by staying with the defined limits. You can give him a free hand to rebalance your portfolio as per his wishes by investing in a balanced fund but then you are foregoing the LTCG benefits in that case. Basically speaking, you can't have your cake and eat it too.

          Balanced funds aren't without its vices either. It's not easy even for an expert to know when to enter and exit the stock market. There are several indicators but none of them are perfect. If stay invested for too long in a bull market, you run the risk of huge loss in case of a crash but if you exit early, you can miss out on a rally and your overall returns will suffer. All these factors play a part.

          Reply
  2. baljit singh

    bhagwaan hai, kahi na kahi ..........
    we have to look for HIM
    regards
    you are doing a great service to the community who believes in facts than desires
    keep it up, sir
    regards

    Reply
  3. sundararajan

    Monthly price > 10-month SMA --> Buy
    Monthly price Sell and move to cash

    Isn't be other way around? Why buy when monthly price is greater than SMA? Am I missing something?
    Ex: Monthly NAV - Rs 10
    10 month SMA = Rs 9
    As per above, one buys at higher than 10 month SMA?

    Reply
  4. AVM

    I use two DMAs, one for 3 months (60 day DMA) and one for 6 months (120 DMA). I never sell, but if the NIFTY is below both these DMA's, I go overweight in the NIFTY and NIFTY JUNIOR Indices along with PPFAS. If above both, I invest only in Debt Funds. If in between both these DMA's, I invest in PPFAS only.

    The reason I don't sell, is because my main aim is to increase the corpus.

    Reply

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