By Max Darnell
Market timing has received a great deal of press lately. No less a luminary than Peter Bernstein has come out in favor of timing the markets, and the interest is visible everywhere. Everyone has a view, but are investors clear about the issues related to market timing? Probably not. (Especially now that the tactics — entirely unrelated to what I'm talking about here — used in today's mutual fund scandal are also being referred to as "market timing.")
Market timing stands at the very core of what active management is all about: it's "buy low, sell high." If some investors aren't convinced that they know whether an asset they are trading is expensive or cheap, they at least have an expectation about whether it is going to rise or fall. Investors are at least trying to time their trades so they buy assets before they rise and sell them before they fall. That's still timing.
If market timing (referring to index level decisions) is no different from the timing implied by the buying and selling of individual securities, why is it so controversial in some circles?
The most important challenge for investors is that the rewards of market timing tend to accumulate over longer time horizons than most investors have the patience for. Markets may trade at excessively high (or low) levels for years at a time before a market correction occurs. The longer the time horizon over which the rewards of market timing are measured, the better the rewards.
Unfortunately, the investment management profession has been geared for a time horizon much shorter than the time horizon attached to market timing. Few are willing to wait for more than two or three years to see their own strategies, or their active managers' strategies, deliver the goods.
Primarily because of this, market timing hasn't become a product in and of itself that is broadly sold in the marketplace. Instead, those who find favor with the notion of market timing tend to turn toward tactical asset allocation, which shares some of the same aspirations as market timing. TAA, however, has gone well beyond the more basic approach that market timing represents. Most notably, TAA practitioners have taken two key steps that seek to minimize the investment-horizon problem, and therefore the corresponding need for outsized patience.
First, an effort is made to determine whether the surrounding market and economic environment supports a reversion in market valuations back toward fair value. We look for catalysts that will spawn a market correction.
Second, by globalizing the approach, we build a portfolio of market-timing decisions in much the same way that a stock investor builds a portfolio of individual stock-timing decisions. This significantly improves the frequency with which relative returns on stocks, bonds and currencies offer opportunities to add value.
By globalizing the approach, value can be added over horizons that don't exceed the tolerance of institutional investors, who tend to look for strategies that are profitable on at least a three-year rolling basis.
Looking forward, TAA might work even better than its recent (successful) track record may suggest. The performance of an investment strategy is ultimately subject to whether the market presents it with the opportunities it would hope to exploit. A big part of what TAA managers have sought to exploit is the interplay between the stock and bond markets.
What interplay, you might ask? In the United States, stocks pretty much just beat bonds over and over again from 1994 through 1999. In only five out of 24 quarters did bonds beat stocks, and in only two of those quarters did bonds beat stocks by a meaningful margin. If TAA is going to profit from shifting between stocks and bonds, then it needs volatility in the relative return of stocks and bonds. The 1970s and the 1980s offered just that kind of volatility, and TAA in its domestic form performed very well then. It would appear to us that the present decade will offer a similar level of volatility. This decade has, so far, been fantastic for TAA.
Market timing has earned back some measure of respect, principally because we've had a dramatic market correction. Market timing worked. It has also gained interest from people like Peter Bernstein because he and many others expect this to be a decade of lower asset class returns accompanied by greater volatility. That's a better environment for market timing, and it's a better environment for TAA.
TAA brings with it a similarly objective and contrarian flavor, but it applies the concept of market timing in a much more diversified portfolio approach that reduces the need for outsized patience. Furthermore, TAA seeks to understand more than just whether the markets are expensive or cheap by asking whether there are catalysts in place that might lead now to the reversion for which market timing waits.
Max Darnell is chief investment officer, First Quadrant LP, Pasadena, Calif.
