WALL STREET GIBBERISH, 2002 FIRST QUARTER NEWSLETTER

Like last issue’s gibberish, I have discussed the current topic in the past, but it is one that never seems to go away, so I will "honor" it by pointing the fickle finger of gibberish at it. The culprit this time is the notion that some insight into whether or not market timing works can be obtained by calculating the effects of missing some number, often ten, of the best and/or worst market days (or weeks or months) over some period of time or every year. The particulars don’t really matter because the whole notion that the analysis tells us something meaningful is completely off base since the scenarios evaluated are quite unrealistic.

The typical article--I am looking at one from an issue of Barron’s last November pretentiously titled "The Truth About Market Timing"--starts out by showing the return for buying and holding an index, usually the S&P 500, for some period of time, from 1966 on in the article. Then the returns if the best n days (n=5 in the article) and only those days are missed each year are shown, and those returns are much lower (what a surprise!). The most blatant anti-timers stop there and say this shows that market timing does not work. More balanced articles, such as the one in Barron’s, go on to show the effect of missing only the n worst days each year. Those returns are, of course, much higher than the buy and hold results. However, I have never seen an article claim that the benefits from missing the worst market days show that market timing is a good idea. Some writers go on to the next logical step and calculate the effects of missing both the n best and n worst days each year. Usually, these scenarios are better than buy and hold because markets tend to drop faster than they climb. The Barron’s article did not take this last step, but it did provide a table of the effects each year starting in 1966 from missing the five best or the five worst days. The implication is that showing these data somehow makes them more meaningful, but the author never questioned or even discussed the validity of the concept.

One problem I have with this type of "analysis" is that no person or trading system is going to manage to be out of the market for only the five (or ten or any specific number) best and/or worst days (or weeks or months) each year (or decade) and be in the market the rest of the time. Consequently, the returns presented are meaningless in the real world. Any timer or system that misses a good portion of the worst days is going to miss some days on which the market gains (and others on which is drops), perhaps some of the best up days. We need to know the effects of those other days to have any hope of meaningful analysis. The whole discussion reminds me of coaches of athletic teams who say "if we had only been able to win the close games we lost, we would have won our division" (or made the playoffs or be in contention for a playoff spot). One day I expect one of them to carry that line of thinking to its logical extreme and say "if we had won the games we lost we would be undefeated!" Or as the old joke goes, "other than that Mrs. Lincoln, did you like the play?"

Another objection I have to the missing the best and/or worst days concept is that it obscures the reasons for using market timing as part of one’s investment plan. I have discussed market timing extensively in back issues including the question of whether or not it works. By "works" I mean making it more likely that a particular objective of the investment program will be achieved. That objective is usually reduction of risk, and market timing can be an effective means to that end. The objective may also be increasing investment returns, and market timing can do that also, but in my opinion, that is a more difficult objective to achieve. Even more difficult is both increasing returns and reducing risk in comparison with buy and hold over long periods of time.

Perhaps the best way in which market timing can work is giving investors the confidence to stick to their plans and keep up their allocations in equities. That confidence results from being out of sizeable portions of bear markets. The major challenge buy and hold investors face is resisting the natural impulse to act out of fear and bail out after the market has fallen. It is easy to buy, but hard to hold when the market falls. After running scared, most of these investors won’t buy back in until the market is much higher than the levels at which they sold, if they buy back in at all.

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