Market Timing

[Gone4Good]

Did I misunderstand?

Perhaps. I don't know, I think we're talking past one another.

Maybe a simple example will help.

Assume I have a $100 portfolio and need to take real withdrawals of 4%. I have two securities to choose from, a risky asset with 5% expected real returns and a riskless asset with guaranteed 3% real returns. I can't reach my return objectives with the riskless asset alone, so I must take some risk. A 50/50 allocation is the lowest amount of risk I can take and still have my expected returns meet my requirements.

Assume that after 1 year, the risky asset doubles in value. My 50/50 portfolio is now worth $150. Because of my windfall, I can more than meet my withdrawal requirements by just investing in the lower returning, riskless asset ($150 * 3% = $45). In light of this development, should I reduce, increase, or maintain my exposure to the risky asset? Conventional wisdom says I'm supposed to rebalance back to 50/50. You suggested possibly increasing exposure to maximize earnings from the favorable trend.

But the simple truth is that I don't need the risky asset at all now. The only reason to own it, is to hope for additional windfalls. But there is another reason to reduce my risk exposure. After an asset class doubles in value (or after a long bull run) future return expectations almost certainly come down. So not only do I need it less, I also expect it to do less for me. The likelihood of another windfall is lower, while the downside risk is the same or higher. So my choice is to sell it down.

 

[GregLee]

You suggested possibly increasing exposure to maximize earnings from the favorable trend.

No, I didn't mean to suggest that you or I could identify a trend. I did suggest that we could identify a top (of interest rates) or a bottom (of stock prices) sufficiently well to profit.

After an asset class doubles in value (or after a long bull run) future return expectations almost certainly come down.

I don't agree to this. Maybe it will just keep going up.

 

[Meadbh]

We've got an old saying in medicine:

The retrospectoscope is a wonderful instrument.

 

[Gone4Good]

I don't agree to this. Maybe it will just keep going up.

I'm a firm believer that valuation matters to future returns. And while there is more to valuation than price, a pretty good first approximation is that any security that doubles in price is going to be valued more richly, and therefore have lower future return expectations after the price increase than before.

Taken together, I have a pretty powerful argument to sell equities 1) my portfolio has grown so I need them less to meet my return objectives and 2) they offer increasingly worse value as the bull market advances.

No, I didn't mean to suggest that you or I could identify a trend. I did suggest that we could identify a top (of interest rates) or a bottom (of stock prices) sufficiently well to profit.

Sorry. It looks like I confused you with the OP who said something about increasing equity allocations in a "bull trend" and reducing them in a "bear trend."

 

[kombat]

After an asset class doubles in value (or after a long bull run) future return expectations almost certainly come down.

I don't agree to this. Maybe it will just keep going up.

The year 2000 called, they want their ..... back .... crap, I was sure there was a joke in there somewhere.

 

[BayBum]

Thanks to all for the thought provoking replies. Glad we could clear this up!

My view is to be fully invested during periods of time when there is less risk in the market and somewhat less invested when there is more risk in the market.
Taking a look at a simple trend indicator such as the 200 week moving average, is there more or less risk owning equities when they are above their 200 week mva? The chart is included here:

What if Market Timing Fails? - Seeking Alpha

BayBum

 

[GregLee]

Taken together, I have a pretty powerful argument to sell equities 1) my portfolio has grown so I need them less to meet my return objectives and 2) they offer increasingly worse value as the bull market advances.

After a price has gone up for a while, it will go down. Yes, I follow that. It's just saying that prices fluctuate. But when will it start downward? You give the rule: after it has doubled in value. Without such a rule, the information that prices go up and down is not useful to an investor. With the rule, it is, but of course only if the rule is sound. Is your rule good enough that you will make more of a profit following it than not following it? This idea that the future price of a security can be predicted from the price's past behavior is called "chartism". It's rubbish.

 

[Gone4Good]

Is your rule good enough that you will make more of a profit following it than not following it? This idea that the future price of a security can be predicted from the price's past behavior is called "chartism". It's rubbish.

I'm not advocating "chartisim" or "market timing" per se. Look at my example in the post above. It's not a question of "beating the market" its a question of evaluating your Asset Allocation in light of your return requirements. The larger the portfolio relative to the real cash flow stream that portfolio needs to produce, the less equities you need. Full stop. End of story.

Most folks here seem to evaluate their Asset Allocation relative to their risk tolerance, automatically taking as much risk as they feel they can bear. It's worth asking the question, do I need to take as much risk as I can stand? After a large equity move like we've just had, the answer to that question could very easily be "no".

 

[Gone4Good]

Taking a look at a simple trend indicator such as the 200 week moving average, is there more or less risk owning equities when they are above their 200 week mva?

From the chart it looks like I'd have maximum equity exposure right at the peak of the 2000 bubble. I'd be buying into the decline about half-way down trying to maintain that allocation. Once the crash was half over, and the index moved below its 200 week moving average, I'd be a net seller of those securities I just bought at higher prices. I'd have my lowest equity allocation at the bottom of the bear, and wouldn't add again until 25% of the subsequent rally was over. Then I'd increase my equity allocation in a rising market, setting myself up to do this all over again in 2010.

That doesn't sound like a good strategy to me.

Do a search on this forum for "200 day moving average" to see how similar buy and sell signals have worked in real time for people who really believe in this stuff.

 

[MasterBlaster]

You need more financial market indicators ! here is a good spot to start. Market Gauge by Dataview, LLC. Click on any indicator to get more information and a chart.

Notice how they all contradict each other. That's always the case. there just isn't a good silver bullet.

perhaps the only indicator worth anything is the PE ratio or perhaps the PE10 ratio. But from the chart, just notice how wrong the PE indicator was for the best buying oportunity we've had in the last decade.

I am not a fan of market timing because I am often wrong.

 

[GregLee]

I'm not advocating "chartisim" or "market timing" per se. Look at my example in the post above. It's not a question of "beating the market" its a question of evaluating your Asset Allocation in light of your return requirements.

What does your AA scheme tell you to do with the proceeds of selling equities? Earlier, you spoke of "taking your money off the table", which would mean keeping it in cash, right? A difficult point for me is that in these discussions, people usually seem to mean by AA, buying bonds when they sell equities. But this is a bet that interest rates will fall. I think there is a market timing issue here, because we can recognize that current interest rates are near an historic low, and so they are unlikely to fall. It's a bad bet.

 

[ziggy29]

If you've won several consecutive bets at the roulette wheel, and have more than enough of a pile in front of you to meet your needs, do you push all of your winnings back on to the table hoping to extend your good fortune or do you take your money off the table?

There are different schools of thought on this.

Some would say that any money in excess of what you need is "play money" and you can take risks with it since losing it wouldn't impact your lifestyle. Others would say that you don't *need* to grow the money so there's no need to take the market risk.

It's similar to someone who receives a large lump sum, who also has a COLA'd pension that more than meets their needs. Where do they put the lump sum? Some would say to be aggressive since they can afford to take the risk (it could go to zero and they wouldn't have their lifestyle dramatically changed); others would say to park it all in cash and short term bonds since they don't *need* to assume any market risk. And I'd argue that neither of them are wrong based on what they value more -- growth potential or stability.

How one answers these questions says a lot about their risk tolerance.

 

[Gone4Good]

What does your AA scheme tell you to do with the proceeds of selling equities? Earlier, you spoke of "taking your money off the table", which would mean keeping it in cash, right? A difficult point for me is that in these discussions, people usually seem to mean by AA, buying bonds when they sell equities. But this is a bet that interest rates will fall. I think there is a market timing issue here, because we can recognize that current interest rates are near an historic low, and so they are unlikely to fall. It's a bad bet.

Buying a bond isn't a bet that interest rates will fall. It MIGHT be a bet like that, but it doesn't have to be, and in my case it wouldn't be. I think if you go back to the simple example above, you'll see that what I'm talking about is hitting a real return target. There are many folks on this message board who talk about drawing 2% or less form their portfolio to live on. That is a hurdle rate that can be achieved with 30 year TIPS and isn't dependent on whether interest rates go up, or down, or sideways.

Another way to think about it using the "FIRECalc" vernacular might be like this . . .

- With a 4% WR my optimal Asset Allocation is something like 70/30, according to historic results
- With a 3% WR I can allocate 25x my withdrawals the same 70/30 and put the balance in TIPS, leaving a ~50/50 AA
- With a 2% WR I can allocate 25x my withdrawals the same 70/30 and put the balance in TIPS, leaving a ~35/75 AA
- Below 2% I can allocate 100% of my portfolio to TIPS (assuming I have room for them in a tax advantaged account)
- If my portfolio is the size of Bill Gates' I can bury my entire stash in mason jars in the back yard and never have to worry about equities or bonds at all (in fact, he can draw $1MM per year for 60 years at 10% inflation and still consume less than 10% of his NW).

So if market returns drive my 70/30 portfolio from a 4% WR to a 3% WR, I can be perfectly justified in reducing my equity exposure as outlined above. I'll plan on holding the extra TIPS securities to maturity so I don't really care what interest rates do, although I'd prefer rates to go up so I can reinvest my coupons at better yields. The balance of the portfolio should, theoretically, cover my needs. If not, I have a nice pot of money earning 2% real to fall back on.

 

[Gone4Good]

Some would say that any money in excess of what you need is "play money" and you can take risks with it since losing it wouldn't impact your lifestyle. Others would say that you don't *need* to grow the money so there's no need to take the market risk.

True. And neither approach is necessarily "right" or "wrong."

But what I don't see on this message board is a discussion of asset allocation that incorporates the ideas you raise in the above quote. If equities increase by 50% the conventional wisdom here is simply to rebalance. I don't get the sense that anyone is making a conscious decision to leave "play money" at risk, even if that is what they're really doing by maintaining a static asset allocation. I suspect plenty of folks might choose not to leave so much of their "play money" at risk once it was identified as such. Others would. But neither, I believe, are currently thinking in those terms.