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Market timing and the business cycle

By David Luhman on Sun, 06/28/2009 - 18:21

Market timing and the business cycle

Market timing explained

If you are interested in trying to beat the market, there are two ways you can try to do it. One way is to try to select those individual securities which you think will do better than other securities. The other way is to try to time the market.

Market timers think that they can find the best time to move into various assets. They think they know when to jump into and out of money market funds, bonds, stocks, and commodities.

The business cycle and securities prices

The business cycle in America typically has lasted four years, and some have tried to link the business cycle to the four-year presidential cycle. At each stage of the cycle, there's usually one asset that outperforms every other asset.

As the economy begins to slow down, bonds are the best investment. As the slow economy dampens inflation, interest rates go down and long-term bond prices rise by perhaps 10 or even 20 percent.

As interest rates fall, however, people find that they can afford to buy more on credit, so the economy picks up. At this early point in the recovery stocks are the place to be. Investors expect that the recovering economy will increase corporate profits, so stocks begin to rise up to 100 percent. You'll want to shift from bonds to stocks at this stage.

As the economy picks up steam, more people find work and factories demand more raw materials for production. At this stage of the cycle you want to shift out of stocks and into commodities.

At the final phase, the strong economy has lead to inflation, and now bond prices already have dropped by perhaps 10 percent. To fight inflation the central bank has increased short-term interest rates to slow down the economy.

As the central bank increases interest rates, stocks will begin a steep slide, eventually losing perhaps 30 percent of their value. High interest rates will cause commodity prices to stop rising, so placing your money in high yielding money market funds now is your best bet for preserving capital while still earning a good return.

With this compressed view of the business cycle, you see certain assets do very well, and others do very poorly, at various stages of the cycle. If you can time the market you can come out way ahead of someone who only buys and holds a fixed mixture of stocks and bonds through the whole cycle.

Problems with market timing

The only trouble is that market timers rarely beat the market, and after accounting for commissions and taxes, market timers almost always lose to a buy-and-hold strategy.

The main reason why market timing doesn't work in practice is that's it's very difficult to tell where the economy is going. Most of the government data is weeks or even months old, and much of it is just plain wrong.

Plus the economy is very complex and unpredictable. Who can accurately track all the things like taxes, interest rates, politics and international trade which will affect the economy. Back in early 1990, who would have predicted that Sadam Hussein would invade Kuwait and this would help to trigger a bear market in the US?

But even if you could sift through the noise and see a distinct path for the economy, it's doubtful that you would be able to profit from it. Let's say that almost every indicator points to a recovering economy so you decide that now's the time to jump into stocks.

The problem is that if the trend is so clear that you've discovered it, chances are that tens of thousands of full-time investment pros also have seen it, and they already have moved into stocks. By the time you get in, most of the easy money already has been made.

I'm not saying that you should ignore the economic cycle, and you might improve your results a little by not following the crowd, but after you consider the effort, commissions, and taxes, you may be disappointed with your results.

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