Sideways – that is the path the U.S. stock market has taken for the last 10 years.  Sure, there have been dramatic ups and downs, but for anyone who bought the Dow Jones Industrial Average in 1998 and held it until now, the end result is zero – 10 years and nothing to show for it.  All of the financial TV talking heads and mutual fund giants will continue to tell you to buy and hold.  In this market and for the foreseeable future, that strategy will not work – not to mention the fact that investing is not a “one-size-fits-all” proposition.  Each individual must consider their risk profile, age and goals in considering how much exposure one should have to the stock market, and if any exposure should be attempted at all.  I have mentioned this in other posts by interspersing it between a discussion of economic indicators, but I believe that one entire post focused on this subject is absolutely necessary at this time, because the market-bottom callers are coming out of the woodwork again.

Below I have reproduced a recent article by David D. Moenning, co-founder of stock market trading service TopGunsTrading.com.  He makes a reasoned argument, using historical market facts (thank you David, I was starting to feel lonely), as to why buying and holding stocks will not do anyone any favors in the current environment.  Though I am reproducing the article in its entirety, if anyone would like to link to the page, please do so by clicking here.  Enjoy the article!

“Is It Time For Timing Again?”

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November 9, 2008
By David D. Moenning I entered this business right out of college in 1980, during a period when the stock market was considered “dead money.” At that time, inflation was raging, interest rates were sky high, the economy was flirting with recession (again), and Time Magazine had just run a cover featuring “The Death of Equities.” The thinking was that since the DJIA had been fluctuating between somewhere around 600 and 1000 for the past 15 years, the sideways action meant nobody was ever going to make any money in the stock market again.

At that time, the concept of “buy and hold/hope” was sheer lunacy. But we should also keep in mind that the mutual fund industry was in its infancy back then. As I recall, in 1982 – right before the market embarked on a spectacular bull market – total assets in mutual funds were something like $82 billion (I’m talking about the assets of the entire industry, not a specific fund or fund family). Nowadays, an $80 billion fund isn’t even the biggest one out there.

The point is that in the early 1980’s, nobody wanted anything to do with the stock market and the only way to make money in stocks was to employ what has since been dubbed an “evil” strategy of market timing.

Buy Low and Sell High? Heresy! I’m not completely sure how the concept of buying low and selling high became a bad thing and so despised by the financial planning community. Well, that’s not entirely true since it probably has something to do with the idea that mutual funds would prefer that you leave your money in their funds at ALL times so that they can continue to collect their fees. And with the explosive growth of mutual funds over the past 25 years, the industry has done a marvelous job in convincing the public as well as just about every financial planner/advisor out there that market timing is a VERY bad idea.

In case you have somehow escaped the endless propaganda, the mutual fund industry touts the horrors of “missing the best 10 days in the market” as a reason for telling you that “timing” can’t be done. The argument suggests that if you are off with your “timing,” you might miss out on the 10 best up days and therefore destroy your returns for the long term.

But as with any good sales pitch, this presentation is almost entirely one-sided (no, scratch that, it is indeed entirely one-sided) and fails to mention the benefits of “missing” the 10 WORST days (of which, we’ve seen a couple lately). It also fails to point out that if you were really clumsy and managed to “miss” both the 10 best days AND the 10 worst days, you would still significantly outperform the market!

Do The Math As for the contention that “market timing” doesn’t work, this is just plain silly. Timing the market (or a stock, or a bond, or a commodity, etc) DOES indeed work and is actually fairly simple to do. For example, while it may be one of the dumbest ways to “time the market,” using reversals in price has proven to work fairly well.

If I could show you a way that you could have beaten the annual return of S&P 500 by nearly 67% per year over 40 years… Would you be interested?

Here’s the details. From mid-July 1968 through last Friday, the S&P 500 has averaged a return of +5.8% per year. However, if you were to simply buy whenever the S&P 500 rises by 8.4% and then sell whenever it falls by -7.2% (a concept developed by the researchers at Ned Davis Research) you would achieve an annual return of +9.7% per year. And by doing the math, we find that 9.7% per year is 3.9% per year greater than 5.8%. Thus, this simplistic approach has been 67.2% better than the market’s return each year for 40 years.

You may have noticed that I mentioned that this was a “dumb” approach. So, yes Virginia, there are better methods of doing market timing. For example, NDR’s computers show that over the past 28 years, when the market (as defined by NDR’s All-Cap equal weighted equity index of 1600 stocks) is below its 25-day moving average AND the advance/decline line is below its 5-day moving average, the market has lost ground at a rate of -29.5% per year. And yet, when both the market and the A/D line are above their respective ma’s, the market has gained ground at a rate of +43.1% per year.

So, I ask you, with two fairly easy methods of “timing” the market available, doesn’t the concept sound better than simply sitting there and taking a beating during a Bear Market? But, unfortunately, there is a rub. The problem is that the vast majority of investors absolutely positively cannot live with the side-effects of such strategies: whipsaws.

You see, the problem is that in looking at our price reversal strategy, we find that only 53% of the signals were correct. This meant that 47% of the “trades” were losers. The bottom line is the public isn’t capable of implementing such a successful strategy because investors equate losing trades with being “dumb” – and very few investors can deal with being “dumb” that often.

What’s the Plan, Stan? Make no mistake about it folks; anybody who has ever bought a stock at $10 and sold it at $15 is a “timer.” Come on, isn’t “buying low and selling high” the whole idea of investing in the stock market?

So now that we’ve established that deep down, everyone is really an evil market timer, it’s time to get to work. You see, it is our humble opinion that what we’re seeing in the market right now is a cycle that may wind up being akin to the 1965 – 1982 period, where the major indices basically moved sideways in a wide range without making any upside progress.

And just in case you disagree with the prognosis, take a peek at a monthly chart of the major indices. In essence, the Dow, S&P 500, and NASADQ have made no progress since the middle of 1998. This means that any of those long-term, buy-and-hope investors are still underwater on the dollars they obediently put into mutual funds at any time since 1999.

Now for the good news… Since we can identify the type of environment we currently find ourselves dealing with, we can also implement strategies designed to succeed in the environment. And yep, you guessed it; this would include a few of those evil market timing strategies.

However, please do not misinterpret our message. We are NOT suggesting that we are going to suddenly change our game plan and start bombing in and out of the stock market with regularity. It simply means that going forward, we will probably be a bit more aggressive with our defensive strategies when sell signals occur and also play the game a little harder when we get big-picture buy signals from our market models.

We should also point out that our stock portfolios already play the timing game (and always have). As you may know, we strive to own only stocks that (1) are top rated in terms of earnings strength and company performance, and (2) present favorable technical setups on a chart basis. And then whenever a stock “breaks down” (examples would include breaks of trend lines, moving averages, or support levels) it is automatically cut from the fold. So, while this may not be the same as pure “market timing,” the approach does allow us to let winners run and cut losses short.

However, at this stage of the game we will be looking to our “timing signals” to tell us when to up the ante in terms of our exposure levels. Remember, at this point in time, we are only buying positions that are between one-quarter to one-half of their normal size. So, until we get some positive signals, we will continue to play the game with a conservative bent.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Co-Founder TopGunsTrading.com

Positions in Stocks Mentioned: None

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The Week in Review Week Month YTD Dow Jones Industrial Average -4.09% -4.09% -32.57% S&P 500 Index -3.92% -3.92% -36.61% NASDAQ Composite -4.27% -4.27% -37.89%