3. Long-Term and Short-Term Market Timing and Investing

The market that we’ve been in for the last 12 years or so has made traders of us all—we simply can not just buy and hold without making periodic portfolio adjustments. There are short-term and long-term considerations, and many investors have started using market timing for their buys and sells. Many others use portfolio adjustment rules as a way to enhance returns and lower risk. Different strategies are explored in this chapter.

The Risk and Reward of Market Timing

Many investors and traders use market timing to take advantage of market volatility, and Figure 3-1 shows why. Figure 3-1 shows the results of investing $1.00 in the S&P 500 Index in 1966, and Figure 3-2 shows the return over a 44-year period with three different scenarios:

• If you had been out of the market on the best five days each year

• If you had been out of the market on the worst five days each year

• If you had simply held the index through the good and bad days of each year

Figure 3-1. Under three different scenarios, a dollar invested in the S&P in February 1966 would have produced very different sums by the end of 2010. (Source: Birinyi Associates, Inc.)

Figure 3-2. The annual changes in the benchmark average under the three scenarios for every year since 1966. (Source: Birinyi Associates, Inc.)

The buy-and-hold strategy would have returned $13.37, which is a decent return. If you had missed the five best days each year, you would have had a very poor return, with only $.03 left on the invested dollar. But if you had missed the worst 5 days each year, you would have had a great performance with the $1.00 being worth $5,349.60.

Why is it so bad to be in the market on down days? Down days are often sharply down. Up days give investors a sense of well being, investors relax, the world is okay, one grows richer, and one gets a sense of contentment, even euphoria. Up markets drift higher. Down markets, on the other hand, are sharp and scary. Fear tops greed as a motivating factor and people throw in the towel and sell as fast as they can, their hands shaking.

There are big differences in performances of each year in Figure 3-1. For instance, 1987 was essentially a flat year. But if you had missed the five best days you would have been down about 20 percent that year, and if you had missed the five worst days you would have been up about 60 percent. In 1975, the market was up more than 31 percent, and without the best five days an investor would be up only about 18 percent. An investor who was not in the market on the five worst days would be up almost 46 percent.

In bear and bull markets, there are sharp short-term moves, and market timing with a small part of your portfolio can increase performance. You can trade individual stocks or use ETFs to short those sectors you think are high or buy those sectors you think are cheap. Enhanced ETFs maximize exposure and can be used as regular or inverse. Inverse ETFs attempt to return the inverse daily performance of an index. For example, an inverse S&P 500 Index attempts to return one percent on the day that the S&P Index goes down one percent.

Using the new ETFs, you don’t have to be in stocks when the stock market is going sideways or declining. Investors and traders can buy asset classes that are low-correlated or not correlated to the stock market. In the sideways market we have been in since 2000, the buy-and-hold strategy hasn’t worked very well. In bull markets, such as the one that started in 1982, buy-and-hold worked. In 1982, you could have bought broad market indexes and received a good return for holding them for 17 years because that bull market went up about 10 times.

Long-Term Investing Using Indexes

There has been much discussion about buying and holding stocks. There is a question about whether that strategy has ever worked, even in good markets. We live in a continuously changing world, and what reality was yesterday quickly fades; the present is upon us. What does this have to do with investing and making money? Actually, plenty. We invest in companies and they constantly change, having to keep up with the demands of the marketplace. When they falter, they are quickly left behind.

I live in San Francisco, and hanging on the wall at my gym are photographs of downtown San Francisco in the early 1900s. The first photo, taken in about 1905, shows people walking on crowded sidewalks, passenger-filled cable cars rolling on tracks in the middle of the street, and horse-drawn buggies packing the streets. The next photo, taken several years later, shows the same downtown scene, the wagons with their bridled horses again filling the street, but also a few box-shaped automobiles, their tops down, looking strange. People probably looked at the autos as a novelty, as people walked on sidewalks, and rode in buggies, tugging on their horses’ reins. The next photo showed buggies and many more cars on the street, the next photo showed a lot of cars and a few buggies, and the next picture showed a street filled with cars, and the horse-drawn buggies were gone.

The surprising thing was the length of time between the first photograph and the last. Was it 25 years or so? No, it was just about 15 years. It took about 15 years for our mode of transportation to completely change. Change is also true more recently. Only 20 years ago we barely used computers, and now we can’t operate without them. Nobody used cell phones about 15 years ago. Remember looking for a public phone and putting in a quarter?

What does this have to do with investing and why it is better to buy indexes than individual stocks for long-term investments?

Well, if you had been investing back in 1900, you might have bought stocks in buggy whip companies, what with horse-drawn buggies being the primary mode of transportation, assuming that people would need transportation and more buggies would swamp the streets. You might not have seen that a buggy whip company investment would become worthless unless the company diversified and changed.

The idea that yesterday’s modern investment might be tomorrow’s dinosaur is discussed in an article by Jason Zweig (The Wall Street Journal, WSJ.com, February 14, 2009, “1930s Lessons: Brother Can You Spare a Stock?”), in which he cites a study that shows that after the stock market collapse in 1929, the only industry to have positive returns from 1930 to 1932 was logging. This was partly because logging companies made matches, which were important back then. As the years passed, matches became less important, and companies that made only matches became extinct, much like the disappearance of buggy whip companies.

When the stock market rebounded in 1933, companies that offered cheap vices made the best returns. These companies included tobacco products, sugar and confectionary products, and fats and oils. In those hard times, people bought things that made them feel better. Some of the industries that did well in the 1930s are extinct or barely exist today, such as leather tanning and finishing.

If you buy and hold stocks and don’t pay attention to those stocks, you are at risk as times change. But if you hold indexes, the index portfolio managers make the changes that conditions warrant.

The Reason to Buy Indexes for Long-Term Investing

Instead of holding stocks for the long term, hold indexes in the form of ETFs, and the portfolio managers will make changes as economic conditions and industries change. For a broad-based, long-term investment, for instance, buy an S&P 500 Index ETF, such as SPY or IVV, or buy a fundamentally-weighted ETF, such as PRF or PRFZ. SPY or IVV offers industry diversification, because those ETFs are broken into nine sectors. The more important a sector is to the U.S. economy, the greater weight the sector will have in the index, and as its importance changes, weightings will be adjusted. PRF and PRFZ also offer industry diversification through their weighting formula.

You also get low-cost money management with these ETFs. The S&P 500 Index portfolio managers meet monthly to keep up with corporate events, and make changes in the index when necessary. The changes are frequent. Between 1964 and 2000, there were about 20 company changes a year in the index.

ETFs are tax efficient. Because of the creation and redemption process, there are usually few capital gains passed on to holders. Broader-based ETFs have had and are expected to have little, if any, capital gains. The difference between your cost price and your sell price is a taxable event. If you hold an ETF longer than a year, it is a long-term capital gain or loss.