Why Market Timing Works
JERRY C. WAGNER
is an attorney and president of Flexible Plan Investments, Ltd. a registered
investment advisory firm based in Bloomfield Hills, Michigan. He is also the
1996-1997 chairman of the Society of Asset Allocators and Fund Timers,
Inc., a national association of investment advisors managing client assets
invested in mutual funds through dynamic asset allocation, market timing,
fund timing, and related disciplines.
Benjamin Graham makes the interesting observation in The Intelligent Investor that, much like the market, different money management styles tend to fall in and out of favor in cycles. When the market goes through a sustained bull market, buy-and-hold becomes the proclaimed path to investing success. When the market enters a bear phase, there is renewed belief in market timing.
With the stock market at new highs, buy-and-hold is looking a bit precarious to many investors. It may be time to take another look at market timing and why its proponents believe timing has great value as a risk management strategy.
Market timing involves moving in and out of the market in response to indicators typically generated by mathematical models. These models attempt to identify either the current trend of the market or the possibility of a change in that trend. Studies of actual results of professional money managers using market-timing techniques reveal that the average timer's results, like the average mutual fund, slightly lag the market indexes.
At the same time, there are a growing number of timers who consistently outperform the market over a full market cycle -- both bull and bear. When risk-adjusted return is used as the standard to measure performance -- as dictated by modern portfolio theory -- even the average market timer outperforms the market by a notable margin (see Wagner, Shellans, and Paul  and Hulbert ).
A study of twenty-five market timers by Wagner, Shellans, and Paul  looks at the level of risk and returns achieved by the timers during the period 1985 to 1990, which includes the bear market of 1987 and the market's three-
month decline in 1990. During this period, the level of risk assumed by the average timer was 40% to 60% below the S&P 500, yet returns were comparable to the S&P 500, even after subtracting fees (Exhibit 1). Even adjusted for relative market exposure (57% in stocks, 43% in cash), the average timer's risk-adjusted return premium remains considerable.
The average annual compounded return on Investment (ROI) achieved by the timers as a group during the period ranges from 13.10% to 14.94%, depending upon whether maximum (2.11%) or minimum (0.5%) fees were charged. This compares to an ROI of 14.85% for the S&P 500 with dividends reinvested, 11.18% for long-term U.S. government bonds, and 6.4% for T-bills.
TIMERS HAVE AN ADVANTAGE OVER BUY-AND-HOLD INVESTORS
Since market timing arose out of the stock market's tendency to expand and then contract, any study of timing's effectiveness must analyze performance during actual bull and bear markets. To do this, we can use the daily history of the stock market's oldest index, the Dow Jones Industrials (DJI), from its first recorded value on July 31, 1885, to the present.
Initially, we define a bull market as any increase in the DJI of at least 10%, and a bear market as any decline of at least a like amount. Then, the same information is compiled assuming a 15% and a 20% cutoff.
Summary results for all three degrees of bull and bear markets are set forth in Exhibit 2. As Exhibit 2 indicates, the bull markets under all definitions have been considerable (32% to 88%), Continued