Many so-called experts would have you believe that it's impossible to "time" the markets.
That's just not true.
There's actually a secret to market timing. It's not just a matter of the economy. It's a matter of how perception and collective psychology gauge the risk of realizing a real profit - doing so with shifting economic conditions as the market's backdrop.
This works for all the markets, including stocks, bonds, commodities, precious metals and currencies.
Look back to 2007-2008 and you'll see that a handful of players got the "timing" right and made billions of dollars. Ever heard of John A. Paulson? He made what is being called the "greatest trade of all time." His hedge fund shorted the sub-prime market and raked in some $15 billion. Paulson's take was a little less. He personally pocketed $4 billion - the equivalent of $10 million a day for the relatively short stretch it took for this trade to play out.
While you wouldn't have been able to amass the capital, leverage, structured positions and risk tolerance of Paulson & Co., you could have seen what Paulson saw, and made a killing. At least you could have saved your portfolio by going to cash before what was already a bad situation got a lot worse.
As for the rally in stocks that started back in early March, there have been plenty of big winners. Goldman Sachs Group Inc. (NYSE: GS) is raking in record profits. Several hedge funds made back their losses and are gearing up both for major profits and for a resumption of the coveted performance fees they'd grown used to collecting until the financial crisis hit.
There's no reason for you to have missed this rally, either. How much you would have made, again, has to do with your personal allocation of capital and tolerance for risk. But if you had employed a "timing" strategy, you would have effectively purchased a seat on the gravy train.
Using the aforementioned examples, let's look at how to generally time market entry and exit opportunities and see how you could have called the housing collapse and correctly timed the March rally.
The tipping point for Paulson & Co. was an analysis of how far housing prices had skyrocketed from historic growth rates. Paolo Pellegrini, Paulson & Co.'s brilliant analyst, also determined how far prices had to fall, or "regress," to get back to their historic norms. And while Paulson was early to the trade - and was actually able to add to his positions even as they initially went against his fund - you didn't need to catch the very top of this play to reap the resultant windfall.
In fact, the No. 1 lesson of market timing is this: It's never a good idea to try and time tops and bottoms.
Leave that to the swing-for-the-fences professionals whose careers prepare them for such risk-taking. Joining the party after it's already started - and then riding along as the trend strengthens and plays out - is a lot safer than being hopeful your mere presence will attract a crowd.
Timing requires a big-picture, top-down perspective. Here's how I look at the big picture: Identify the largest constituent elements that move the stock, sector, industry or economy you are measuring. For housing, I look at the availability of credit, the cost of credit, the trajectory of growth, and the sustainability of those trends.
In 2007, I used Countrywide Financial Corp. and IndyMac Bancorp. Inc. (OTC: IDMCQ) as proxies for credit availability, and I used interest rates on adjustable rate mortgages (ARMs) and the profitability of big banks as a proxy for the cost of credit. I followed the trajectory of growth around the country simply by reading the real estate sections of newspapers. By the fall of 2007, it was easy to see strains on the proxies I was watching, even though closer to home everything looked rosy.
Both Countrywide and IndyMac faltered. That told me there was a problem with the sustainability of credit extension, especially in the subprime-mortgage market where both had made a giant push. You didn't need to read their balance sheets or income statements, the newspapers were full of telltale stories. There was plenty of evidence that teaser rates were giving way to higher rates and strains were developing on borrowers.
At the same time, big banks were having a harder time syndicating and selling off covenant-lite debt pools of leveraged loans. And there was plenty of noise about banks' shaky structured investment vehicles (SIVs), created to finance and hold risky mortgage-based assets off of their balance sheets. It became obvious that none of the trends that propelled housing were sustainable. You could just have easily seen it, too.
The tipping point for me was a couple of big quarterly losses at Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). The ultimate proxy for the entire housing market was flashing red; it was time.
No, I didn't catch the top. But, I told the readers of my blog to get out of the markets entirely and into cash in February 2008. Not cash proxies like money market funds. I mean cash.
If you were employing a timing strategy, even if you missed the exact turn - as I did - you would have locked in built-up profits, as opposed to losses.
You do that by applying the second lesson of timing: Because no one has perfect timing, a timing strategy requires investors to place profit-target orders and stop-loss orders across their portfolio holdings.
Lots of you had soaring profits in the run-up to late 2007. And even if you employed a "dance-‘till-the-music-stops" strategy, if you didn't take profits and didn't have stop-loss orders in place, when the music did stop you fell on your rear.
The lesson here is that exact timing is impossible. But profitably timing your exits is a simple matter of emphasizing prudence over greed.
In 2007, investors put little stock in a collapse of the housing market. That was evidenced by the tiny risk premiums investors were demanding on housing-related debt. By March 2009, quite the opposite was happening.
Perception and psychology had certainly changed. The perception that we were headed over a cliff and the collective psychology to avoid any further pain created a giant spread in the risk premium investors applied over non-existent growth prospects. And again there was a flashing light that market timers saw as a beacon.
While I can't speak for the other market timers that got it right, I can tell you that although I missed the exact turn, I am on the record in calling for a strong rally from the end of March.
My timing lights were flashing because the risk premium (implied perception and psychology) for holding financial assets had created a spread so wide that even the hint of potential profitability would trigger a rally. It looked like it may have started, but I needed a macro model to analyze the whole market.
I used a simple supply-and-demand equation to stress test the timing of my desire to re-enter the market. My proxy for "supply" was the actual level of shares outstanding in the market (a level that had fallen dramatically over the previous decade) - and their newly cheaper prices. My proxy for demand was cash on the sidelines and the difference between investors' holdings of short-term U.S. Treasuries before the crisis and those same holdings at the beginning of March.
At some tipping point, it was obvious that no matter what the perception and psychology actually was in the marketplace, even a few small waves of demand had the potential to swirl into an investment tsunami that would take prices higher. When I saw prices rising on increasing volume, I knew that successive waves would continue to lift prices, regardless of actual profitability or sustainability of corporate earnings.
Given what we've learned from these recent experiences, the question is now very clear: Where do we go from here?
Well, there are two destinations in the future. One is near and the other is farther on up the road. We need to discuss them both.
In the near term, good timing will be a function of the supply-and-demand equation. Stocks should go higher as more money comes off the sidelines and out of low-yielding U.S. Treasuries. Who knows how high the markets can go if retail buyers actually become buyers again?
Make sure to employ profit targets and reasonable stops. I suggest 15% lower than your point of entry.
Timing is more important when looking farther up the road. We're going to have to see real sustainable growth in profitability - well above the anemic levels that currently pass for robust when compared to the dark days of 2008.
Frankly, it's a race. Will an economic rebound generated by massive government stimulus make up for - and even surpass - the still-stalled engines of our consumer-driven economy? Or will weak fundamentals swamp a fragile recovery when government-support systems are dismantled?
As never before in the modern era, timing is going to be critical to investors. There will be no more dart throwing, no more sitting back and watching all boats rise with the tide. There will be no more one-way bets.
The nature of an increasingly global economy will show its own propensity for swiftly moving capital. And if investors don't become adept at timing, time will run out on their prospects for grabbing and keeping fleeting corporate profits, a key part of the march to amass truly permanent wealth.
Editor's Note: The Author Shah Gilani is a retired hedge-fund manager and a leading expert on the global credit crisis
