Market Timing and Tactical Asset Allocation

Market timing, as the name implies, tries to time purchases and sales to the phases of the market. If this could actually be done, money would grow on trees. In the past ten years, catching the major swings would have more than tripled the results of simply buying and holding the S&P 500.

Market timing is a hybrid of fundamental and technical ingredients. Market timers watch the trend and level of interest rates, the degree and direction of business activity, 1 profits, industrial production, etc. If, for example, inflation is decelerating, interest rates have peaked and are edging down, and employment is beginning to pick up after a decline, economic factors are considered favorable. If technical patterns are also encouraging, a strong buy signal has been given. On the other hand, if inflation is creeping ominously higher, accompanied by rising interest rates, while profitability and employment are beginning to slip, and technical pattems look menacing, we know its time to sell. What could be simpler?

Unfortunately, real market movements give dozens of signals, madly flashing buy, sell, and hold all at once. To further complicate the situation, institutions watch the same leading technicians (Robert Farrell, Bob Preohter, Elaine Garzarelli, and a handful of others) and the same

An even more troublesome question: Why have the conservative proponents of the Graham and Dodd model not outperformed, or even kept up with, the market as a whole? First, standard analysis increasingly emphasizes near-term outlooks while downplaying other key fundamentals, thus abandoning one of Grahams key principles. Forecasting is the most important factor in contemporary securities analysis. As we shall see in chapter 5, research analysts forecast poorly. Chapter 5 also demonstrates that even a moderate miss can devastate a stocks price.

Second, although certain issues may be substantially undervalued, there is no guarantee that the market will recognize it. The stocks may Unger in the dumps for years.

Warren Buffett gave a third reason. He said he consistently applied fundamentals that "others cavaUerly disregarded." But were they disregarded? Or were their adherents forced by weaknesses in the methods to abandon them, most often involuntarily? Part II will examine this question in some detail. Meanwhile, lets look at methods bom of mixed fundamental and technical lineage: market timing, tactical asset allocation, and momentum.

Momentum

The final fundamental-technical hybrid, which has gained major popularity in the last few years, is momentum investing. Managers of value

indicators, as well as each other. Thus, the major money managers will all react to the same information at the same time. Since they currently control a large percentage of stock trading, market timing may create a self-fulfilling prophecy that exacerbates market swings.

Various academic and institutional studies, as well as the long-term performance of money managers who practice this method, indicate that market timing doesnt work. To time markets profitably, Nobel laureate William 8 finds that a money manager must call three moves out of four, after commissions and transacdon costs.

In light of these and similar findings, increasing numbers of investors have tumed to tactical asset allocation (TAA), particularly after the 1987 crash and the 1990 free fall, which caught most market timers napping. Like its less sophisticated sibling, TAA promises to move the investor into and out of the market at the right time. It also states it will shift the portfolio mix (normally stocks, bonds, and cash) as conditions change. Most TAA signals are based on both economic and market indicators. In the end, TAA, in spite of its more respectable title, still depends on some kind of fixed formula or on technical analysis.

While many professionals regard TAA as simply another form of market timing, adherents violently disagree. Does it work? The figures are not encouraging. Figure 3-1, taken from Lipper and Momingstar data, shows the retums of 186 asset allocators for the 12 years to September 1997 compared to the S&P 500 and the average of all domestic equity funds. The period covers a good part of the bull market, as well as the 1987 crash, and the sharp downtum in 1990. This was the ideal time for market timers or asset allocators to prove their mettle. They should have got you out before the 1987 and 1990 debacles and back in on time to ride the resurgent bull. Had they succeeded, you would have outperformed the market handily.

As the chart shows, heroes they aint. While the market surged 734% over the entire period, and the average equity fund moved up 589%, the asset allocators increased only 384%, about half the gain of the averages (all figures are dividend adjusted). Tactical asset allocation has obviously not set the world on fire. In fact, its downright awful, even in the periods where asset allocators claimed they swept the field.

The prosecution rests.

S&P 500 Total Retum Index +734%

All Domestic Equity Funds* +589%

sset Allocation Funds +384%

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1

S&P 500

All Funds

---Asset Allocation Funds

Sources of data: Upper Analytical Services and Momingstar

* "All Funds" is an asset-weighted index of the compounded returns all equity mutual fund categories followed by Momingstar.

t Returns measured through September 30, 1997.

and growth funds alike use this method. A momentum investor buys stocks that are outperforming their industries or the market, and sells them when they lag. Although eamings momentum is the most common method, this technique can be used in other ways. Investors can purchase stocks that are outperforming and liquidate unde erforming issues (not unlike conventional technical analysis), or they can look at sales momentum. A momentum analyst can also follow various fundamental yardsticks, but emphasizes accelerating eamings growth quarter by quarter. And so on.

Trouble is, with the increasing popularity of this method, many managers are playing the same game. So much so that they jump on the same figures at the same time, jerking the price sharply. Thus, as momentum slows for a favored stock, everyone scrambles for the exit simultaneously, and the price tumbles. Which is precisely what happened to momentum players in technology stocks in late 1997. Momentum had been

Figure 3-1

MISTIMING

Compounded retums of asset allocation fimds versus all domestic equity fimds and the S&P 500