The economic recovery is gaining momentum.  In late August, the Commerce Department reported that 2Q Gross Domestic Product grew at an annual rate of 3.1% versus its previous “advance” estimate of 2.4% in July.  3.1% more than doubles the 1Q growth rate of 1.4%.  The Index of Leading Economic Indicators rose 0.4% in July, marking the fourth consecutive monthly increase.  Based on reports released over the last month or so, more and more analysts now expect the economy to hit a growth rate of 4-5% in the 3Q.  The Bank Credit Analyst agrees with this view and expects the economy to “surprise on the upside” over the next year.

The deflationary threat has passed for this cycle, and you should expect to hear new warnings about a new inflationary trend.  The gloom-and-doom crowd will no doubt jump on this issue as the next crisis around the corner, but inflation will not be a serious problem anytime soon.

Stocks continue to edge higher and this trend is likely to continue, especially given the stronger economy.  Even though stocks are pricey by some popular benchmarks (P/E Ratio, etc.), there is a mountain of cash on the sidelines that can push equities higher as confidence in the economy increases.  Treasury bonds, on the other hand, will not benefit from the stronger economy.  Long-term rates could continue to creep higher.  I continue to recommend Capital Management Group for your bond investments.  They are having another outstanding year.

This month, I offer “The Definitive Case For Market Timing.”  A prominent investment guru shocked the financial community earlier this year by openly endorsing market timing, after years of criticizing it.  In this issue, I will tell you why, and I will present you with some new statistics on market timing versus buy-and-hold that will surprise you.  This information flies in the face of traditional Wall Street investment philosophy.  I hope you read the following pages very carefully.

I believe this is one of the most important newsletters I have ever written.  But due to its content, it will not be popular with the financial media.  For that reason, I am waiving my copyright protection on this issue of F&T so that you may share this information with others.

Time To Time?

In late January of this year, noted investment and economic consultant Peter Bernstein shocked the institutional investment world by uttering the following:

“What if we can no longer be so confident that stocks are necessarily the best place to be in the long run?  What if moving around more frequently is now a necessity rather than a matter of choice?  I am talking about market timing – dirty words.”

Dirty words, indeed!  In making this comment, Mr. Bernstein broke away from the herd of buy-and-hold adherents in the institutional investing and financial planning communities, and even with his own past writings and opinions.

Though Mr. Bernstein made his speech in January, it has taken until now for the ripple effect to get to the mainstream financial press.  An article appeared in Registered Rep magazine in June of this year, and the most recent ripple occurred in the Wall Street Journal on August 27th.  I guess the financial press put a lid on his comments as long as they could, but eventually had to let the cat out of the bag.

I recently wrote about market timing in my “Mutual Fund Merry-Go-Round” series in the weekly Forecasts & Trends E-Letter, which you can review by going to the ProFutures website ( www.profutures.com ).  In light of Mr. Bernstein’s comments, I thought it would be beneficial to revisit this subject as it is sure to gain additional attention in the mainstream financial press and on the Internet.

No Industry Lightweight

You may be wondering why this speech by Mr. Bernstein is such big news in the investment world.  After all, financial consultants (like me) have been advocating market timing for years, and it has always had its supporters and detractors.  The answer to this question lies in the clout Mr. Bernstein has in the investment community, and the journey he has taken to get to where he now advocates market timing over conventional buy-and-hold investing.

Peter Bernstein has been a prominent fixture in the investment world for more than 50 years.  He graduated from Harvard College in 1940, and after a stint in the Air Force, entered the investment industry as an economist.  He later took over his family’s money management business, and went out on his own when the family firm was acquired by Sanford Weill in 1967.

He is probably best known in the world of academics and institutional investors who control trillions of dollars and often allocate tens (or hundreds) of millions of dollars to a single investment.  He was the first editor of the Journal of Portfolio Management and is also renown for his newsletter, Economics and Portfolio Strategy.  The readers of his newsletter alone are reported to own or manage over five trillion dollars , and his circle of friends includes such notables as Nobel Prize winners Paul Samuelson, Harry Markowitz, and William Sharpe.

Obviously, Mr. Bernstein is a real heavyweight in the field of economics and investments, so his conversion to the market timing camp is very significant.

I say that he has been “converted” to market timing because in his 1996 book entitled “Against the Gods: the Remarkable Story of Risk,” Mr. Bernstein advocated sticking to a strict asset-allocation strategy (buy-and-hold) and took a very dim view of market timing strategies.  He identified market timing as a risky strategy because of the possibility of being out of the market on days when there were big upward moves.  This is the age-old myth used by Wall Street and others to try to disprove market timing, but the studies it is based on have a fatal flaw that I will discuss later on in this article.

To be fair, I have to admit that the type of market timing advocated by Mr. Bernstein is not necessarily the type of market timing that is typical in the industry.  In fact, in the Journal article, Bernstein stressed that he is not advocating “rapid-fire” trading. 

However, there are many programs such as those I discussed last month offered by Capital Management Group, Potomac Fund Management, and Niemann Capital Management that do trade in a manner much like that suggested in Bernstein’s speech.  Yet even some rapid-fire programs such as the one offered by Hallman & McQuinn were successful in limiting losses during the recent bear market.

As might be expected, Mr. Bernstein’s January remarks have touched off a hot debate among institutional money managers, especially those in the high-stakes world of pension fund investing.  When investing pension money, as with most trusts, the money manager has a fiduciary responsibility to manage the money as a prudent investor.  What if buy-and-hold is no longer a slam-dunk prudent investment strategy?  The liability could be huge.

The Reasoning Behind Bernstein’s Comments

As I have discussed in my writing over the last year or so, most market analysts, including the folks at The Bank Credit Analyst, believe that stock market returns will generally be lower in the foreseeable future than they have been in the past.  Statistics tell us that the historical annual average returns on stocks are somewhere in the 10% - 11% range, depending upon who you read and what time frame you select.

In the next 10 to 20 years, however, most analysts predict stock market returns will be more in the 6% to 8% range, but they also predict no such reduction in the market’s volatility.  In other words, following a buy-and-hold strategy will amount to taking more risk for a lower potential return, if the predictions are accurate. 

The Journal article goes on to say: “In such an investment environment where the chances of losses are the same but the rewards are smaller, ‘the risks of being out of the market when it goes up are much less if the upswing is a short-run rather than a long-run development,’ Mr. Bernstein said in January.”  This, apparently, is what led Mr. Bernstein to take a serious look at market timing as a viable alternative investment strategy to buy-and-hold.

Bernstein Is Not Alone

As you know, I have been promoting market timing strategies since 1995.  All the while, Wall Street has continued to hammer away that market timing doesn’t work and that investors should just buy and hold stocks or mutual funds, preferably ones that they sell.  There have been many other adherents to the market timing investment philosophy, but they have been largely outside of the mainstream financial services industry, and certainly not part of the financial media.

However, I reported in the January 2002 edition of this newsletter that The Bank Credit Analyst advocated market timing strategies for the first time, based on their predictions of future stock market conditions.  Here’s an excerpt of what I said back then:

“In the 25 years I have been reading BCA, I don’t ever remember them embracing market timing.   Their approach has always been buy-and-hold with only the allocations between stocks and bonds changing periodically.  However, a couple of issues ago when they predicted that the economy and the stock markets would recover in 2002, they suggested the use of market timing strategies, for the first time I can remember.  Now, in their latest two reports, BCA says buy-and-hold is not the best strategy, at least for the next year or so.

Yet in the volatile scenario they envision, I can certainly understand why they would switch to this position.  First off, investors who buy individual stocks are going to have to be very adept at selecting those stocks where the valuations are not still dangerously high.  Most investors are not good at this.  Second, even investors who buy only mutual funds are going to have to be flexible and able to switch among sectors from time to time.

Third, and most important, investors will have to be much more watchful of economic developments and may need to get partly or fully out of the markets from time to time.  That is the definition of market timing.”

(You can read the entire discussion about BCA’s stance on market timing in the January 2002 issue of F&T.  Just go to our website at www.profutures.com, go to the “Newsletters” tab at the top of the page, and click on “Forecasts & Trends Newsletter.”  This link will take you to an archive of past issues of F&T.)

As the bear market has laid waste to many investment portfolios, more and more traditional investment advocates have started to widen their list of acceptable investments.  Some, like MIT’s treasurer Allan Bufferd (who also spoke at the January institutional investor conference with Mr. Bernstein) have found that “much more flexibility was necessary.”   I guess he just can’t bring himself to say “market timing.”  

However, to be fair, Mr. Bufferd did advocate the flexibility of “hedge funds,” many of which employ market timing type strategies.  Unfortunately, hedge funds are unavailable to most individual investors because of net worth requirements and high minimum investments.  Fortunately, there are other ways to access this flexibility, as I will discuss later.

Bernstein’s comments are also likely to spur the production of a number of books on the subject of market timing.  One already out is authored by Ben Stein, an exceptional individual who has served in such varied occupations as speech writer for Richard Nixon, attorney, actor, game show host and prolific columnist and editorial writer on political, economic and investment topics.   Stein’s book entitled “Yes, You Can Time The Market ” disputes the myth that you can’t tell when the market is going to go up or down, backing up his case with a wealth of historical statistical data.

Not Everyone Is A Believer

Of course, not everyone in the investment world was swayed by Mr. Bernstein’s comments.   John Bogle, founder of the Vanguard Funds, believes that Bernstein is wrong in advocating market timing (what a surprise, coming from the founder of a mutual fund family!).

Likewise, Roger Ibbotson, founder of the Ibbotson investment consulting firm, says that most investors shouldn’t try to make market timing calls.  While he concedes there are often short-term imbalances in the market, he doesn’t think that the average investor has the ability to identify or capitalize on these imbalances.

(I actually agree with Ibbotson that most individual investors can’t time the markets successfully on their own.  That is why I recommend market timing only under the direction of professionals.)

Now that Bernstein’s comments have broken out of the limited exposure of the institutional investment market and made the pages of the Wall Street Journal, you can look for other notables in the investment world to denounce his market timing advice.  After all, buy-and-hold is the bread and butter of mutual fund companies and brokerage firms.

Wall Street’s Flawed Theory On Market Timing

As Wall Street’s media machine starts to combat this challenge of their conventional wisdom, look for them to use the most flawed piece of statistical investment mythology to be floated as the reason not to try to time the market.  Most brokerage firms and mutual fund companies have a stock answer for market timing (Don’t try it!), based on any number of statistical studies using historical stock market performance.  But their most popular theory is flawed!

The story goes like this:  Historically, much of the stock market’s upward moves are concentrated in a relatively few number of days (which is true).  If market timing takes you out of the market on those days, then your returns will suffer dramatically.  Therefore, they say, it is important that you stay in the market so that you will not miss these good days.

One such study that I have seen analyzed performance over a period from April of 1984 through May of 2000.  Over that period of time, the S&P 500 Index produced an average return of 15.02%.  However, the study shows that if you missed the 10 best days in the market over that period, your return fell to 11.59%. 

Missing more of the best days means even lower returns.  For example, if you missed the 40 best days in the market, your average return would only have been 5.77%.  Thus, Wall Street reasons, if you want to maximize your returns, you have stay in the market so that you don’t miss the good days.

While the numbers they quote are accurate, this analysis is obviously skewed to fit the viewpoint of the buy-and-hold crowd.  It is flawed because it assumes that a market timer would be out of the market on all of the best days, but in the market on all of the worst days.  Unfortunately, many investors buy this argument hook-line-and-sinker without thinking to ask the question, “What happens if you miss the bad days in the market?”

This is a very critical point, so let’s bring it out  into the light!

The Society of Asset Allocators and Fund Timers, Inc. (SAAFTI) is a trade association of money managers including active managers who practice market timing.  SAAFTI saw the obvious fallacy in the above argument and did further analysis that paints an entirely different picture.

Instead of missing the good days in the market, let’s say that a market timing Advisor allows you to miss only the worst days in the market.  Using the same data as above from April of 1984 through May of 2000, if you missed just the 10 worst days in the market, your return would have been 20.89% vs. the 15.02% Index return.  Now that’s impressive!  As you increase the number of worst days missed, the numbers get even better, resulting in a return of 28.13% if you missed the worst 40 days in the market over this 16-year period of time.

Of course, this analysis is as flawed as the first one, since it assumes that the Advisor is smart enough to be out of the market on all the worst days, but in the market on all of the best days. 

A More Realistic Analysis

Since both sets of performance numbers discussed above are skewed to fit one approach or the other, neither is useful to the knowledgeable investor.  However, SAAFTI continued in their study to see what would happen if an Advisor missed BOTH the best and worst days in the market over the 16-year period discussed above.  The results are pretty amazing. 

If you missed the 10 best and 10 worst days in the market, the resulting return would have been 17.29%, as compared to the 15.02% S&P 500 Index return.

As the number of best and worst days missed is increased, the percentage return stays essentially the same.  For example, if the best and worst 40 days are all missed, the return would have been 17.83%, still over 2% better than the S&P 500 Index return over the same time period.

What About The Bear Market?

Since the SAAFTI study analyzed numbers only through May of 2000, just as the bear market in stocks was in its infancy, I wondered what effect the bear market had on the best/worst analysis.  Since ProFutures is a member of SAAFTI, I contacted them and asked if they could update the numbers for me through the end of 2002, which they gladly agreed to do.

The SAAFTI update of the S&P 500 Index performance from April of 1984 through December of 2002 showed the Index produced an average annual return of 9.66%.  This drop from the 15.02% average return of the previous study illustrates the obvious effect of the three-year bear market on the long-term average return of the Index.  The table below shows the effect of missing various combinations of best and worst days in the market over that 18+ year period.

(Source: Society of Asset Allocators and Fund Timers, Inc.  This data is for illustrative purposes only and is not indicative of the actual performance of any investment.)    

Thus, while the average annual return percentages showed the results of the bear market, the basic result stayed the same: missing bad days in the market can more than compensate for missing out on the good days.  Even when the general direction of the market was downward, missing out on the worst declines still proved effective in enhancing performance.

Putting The SAAFTI Study In Perspective

While it may be the goal of every market timer to be in the market only on the good days and out of the market on all of the bad days, we all know that such a perfect system doesn’t exist.  In my Special Report on market timing that I made available on our website in December of 2002, I discussed that the ultimate goal of market timing, in my opinion, is not necessarily beating the market, but to attempt to control the downside risk of being in the market.  (This Special Report is still available on our website.  If you don’t have Internet access, just give us a call and we’ll send you a copy.) 

I base my opinion upon studies such as those done by the Dalbar organization that demonstrate the negative effect of emotional trading upon investors’ long-term returns.  We all know how it is when we lose money on an investment.  Should we stay the course, bail out and go to cash, or move to something that seems to be performing better?

The above analysis by the SAAFTI organization shows the value of being out of the market on the worst days, even if you miss some or all of the best days.  Much of the reason missing the best days doesn’t matter as long as you miss the worst days is that the worst days are often far worse (in terms of percentage loss) than the best days are good.  For example, if you calculate the sum of the 10 worst days over the 16-year period of the original study, the total comes to -75.47%, while the sum of the 10 best days is only +49.68%.

Plus, there’s the impact of the mathematics of gains and losses.  If you lose 20% on your investment portfolio, you have to make a 25% gain to return to breakeven.   During the recent bear market, the S&P 500 Index experienced a drawdown of –44.71%.  It will take total gains of over 80% just to get back to break-even, and there’s no guarantee that will happen.

Going It Alone Vs. Professional Management

In my Special Report on market timing, I provide a wealth of information designed to help do-it-yourself investors employ market timing.  This information is based on my many years of experience in analyzing successful professional money managers, as well as my own personal experience.  At the end of the day, however, it is usually not feasible for individual investors to try to time the market on their own.  

The reasons for this are many, but the most common one I get from my clients is that they don’t have time to develop a trading system, and then monitor market data continually.  Most investors have a life outside of their investments and do not want to commit the time and effort necessary to attempt to time the market effectively.

Another reason that individual investors don’t do well in timing the market is a matter of emotions.  When losses occur in your account, do you have the discipline necessary to stay with your system and ride them out?  Many investors do not.  They start questioning the validity of their trading methodology and sometimes get into or out of the market at the wrong times.

For these and many other reasons, I learned long ago to trust my money to professional market timers who have developed and tested their own systems, have successful actual trading records, and have an operation set up to monitor the markets and execute the trades necessary to move in and out of the market.

Even The Pros Use Professional Management

As I discussed earlier in this article, even professionals who manage trillions of dollars in institutional funds do not attempt to manage all of those funds on their own.  They seek out proven professionals to manage their funds and spread their money around to achieve diversification.  Because institutional investors have the ability to invest large sums of money in a single manager, they have access to the most successful money managers who require millions of dollars to invest with them.

Obviously, most individual investors cannot afford million-dollar-plus investment minimums and, even if they could, would usually not be able to gain much diversification.  In addition, most individual investors cannot access hedge funds, which are another option open to the large institutional investors.

In fact, institutional investors are actively courted by hedge funds because they can write big checks, which is important in a fund that, because of regulatory restrictions, can only accept 99 investors.

Timing Strategies For The Individual Investor

For those who can’t write million dollar-plus checks, there are alternatives.  Earlier I mentioned the SAAFTI organization and how it is a trade association of market timers and other active management professionals.  SAAFTI is a good source for information on Advisors who manage money directly using active management techniques.  These firms make market timing and other active management strategies within reach of most investors.

However, selecting an effective market timer is not as easy as going to the SAAFTI website or an Internet search engine and picking a name from a list.  Sure, you can find plenty of firms claiming to be market timers, but are they actually successful?  How long have they been in the market timing business?  Do they have an actual track record with real money or are all their impressive results just hypothetical, “paper trading” results?  How much money do they manage? Do they have a strong “back-office” to be able to handle the administration of the accounts they manage?  And is it necessary to actually visit the Advisor’s office in person?  I believe it is, but this can be very expensive and time consuming.  At ProFutures, we do an advance on site due diligence visit for EVERY market timing Advisor we recommend to our clients.

ProFutures’ ADVISORLINK  Program

That’s the reason that I started our AdvisorLink program in 1995 at the request of my clients who were searching for money managers who could potentially limit the downside risk of being in the stock market.  Since I wrote about three of the Advisors in our AdvisorLink program in last month’s F&T, I’m not going to retrace that same ground.  What I will do is recount some of the things we have learned over the eight years since launching the AdvisorLink program. 

First of all, I have learned that even professional market timers, including those with long impressive past track records, can experience problems and must be monitored continually.  Occasionally, the problems are serious enough that the Advisor has to be terminated.  Some Advisors have let their emotions get in the way and they override their trading methodology.    Or they change their trading system to the point that it is a virtually new system with no performance record. Still others have systems that are designed for a certain market environment, such as a bull market, but won’t work in other market environments.

Another thing I already knew and the AdvisorLink program has reinforced, is that a successful historical track record is no guarantee of future performance.  Since 1995, we have looked at hundreds, if not thousands, of potential market timing Advisors.  We have hired some of the most impressive names in the business, and all of these had impressive credentials and long historical track records.  Even so, we hired some previously very successful Advisors whose programs lost their “magic touch” in the market, and experienced losses.  In these cases, we recommended that our clients move their accounts to other Advisors.

This is a very important point.  There are very few money managers who will ever advise a client to close his or her account.  In most cases, a struggling money manager will strongly encourage clients to “hang on” until things get better.  Often, they will tell clients that they’ve made important changes which should improve performance.  The client, who may not be qualified to evaluate the manager’s story, may be convinced to hold on, and more losses may follow.

That’s where I see the true value of a program like AdvisorLink .  We monitor all of the Advisors we recommend on a daily basis to see if they are performing acceptably.  How do we do that?  I have personal accounts with every Advisor we recommend.  By monitoring my accounts each day, we can see how the Advisor is doing.  We can also see if there are changes  in the performance patterns.  In addition, we talk to the Advisors frequently.  Some Advisors prefer not to talk to individual clients, especially frequently, but because ProFutures represents a large block of clients, the Advisors are happy to take our calls and answer our questions.  The good ones are also happy to have us come for on site due diligence visits periodically.

The point is, we stay on top of the Advisors we recommend, and if ever there is a reason to get out of any of these programs, we will tell you.

Conclusions

I hope this article has helped you to better understand the merits of market timing.  I have been a firm believer in market timing for over a decade.  Now others, including some very prominent others like Peter Bernstein, are coming to agree with me.  Of course, it took a bear market for them to come around.

The objective of market timing, at least in my opinion, is to reduce risk while earning reasonable returns.  If the returns on stocks are going to be lower in the years ahead, but the risks will be the same or higher, a buy-and-hold-only  strategy is not attractive to me.  Market timing is where I want to have the bulk of my equity investments.  Because we represent a large number of clients with tens of millions invested, we have the necessary resources to:

1. Continually monitor the Investment Advisor universe to find successful managers for our clients;
2. Perform our rigorous due diligence on potential Advisors, including on site visits to their offices;
3. Monitor each Advisor on a daily basis and communicate with them frequently or as needed; and
4. Recommend that you move to a different Advisor(s) should performance not meet expectations.

Most importantly, we’re on your side of the table, providing independent, objective information as well as diversified options for your investment portfolio. 

In closing, let me emphasize that I believe market  timing strategies will prove to be crucial in the years just ahead.  The markets will continue to be very volatile, especially in the post-9/11 world.  The threat of terror will be with us for a long time.  As a result, I believe you need at least part of your money with market timing Advisors who have the ability to move to the safety of cash should conditions warrant. 

If you would like more information about the various investment programs recommended under our AdvisorLink service, feel free to us a call toll free at 800-348-3601 and talk to one of our Investor Representatives.  You can also visit our website at http://www.profutures.com, or send us an e-mail at mail@profutures.com.

Remember, you are free to reproduce or share this issue of F&T with others as I am waiving my copyright protection for this issue.  Or we will be happy to provide additional copies if you prefer. 

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