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This article has multiple issues. Please help
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This article's Criticism or Controversy section may compromise the article's
of the subject. Please
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Market timing is the strategy of making buy or sell decisions of financial assets (often ) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from
analysis. This is an
based on the outlook for an aggregate market, rather than for a particular financial asset.
Whether market timing is ever a viable investment strategy is controversial. Some may consider market timing to be a form of
based on pure , because they do not believe in undervalued or overvalued markets. The
claims that financial prices always exhibit
behavior and thus cannot be predicted with consistency.
Some consider market timing to be sensible in certain situations, such as an apparent . However, because the economy is a
that contains many factors, even at times of significant market optimism or pessimism, it remains difficult, if not impossible, to predetermine the
of future price a so-called bubble can last for many years before prices collapse. Likewise, a
can persist
stocks that appear to be "cheap" at a glance, can often become much cheaper afterwards, before then either rebounding at some time in the future or heading toward .
Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka, . Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a
strategy with periodic "re-balancing".
Others contend that predicting the next event that will affect the economy and stock prices is notoriously difficult. For examples, consider the many unforeseeable, unpredictable, uncertain events between 1985 to 2013 that are shown in Figures 1 to 6 [pages 37 to 42] of Measuring Economic Policy Uncertainty. Few people in the world correctly predicted the timing and causes of the
has published a review of several relatively simple and statistically successful market-timing strategies. It found, for example, that "Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data" and that "the strategy based on the spread between the
and a short-term
comfortably and robustly beat the
are incorporated".
often use proprietary market-timing software developed internally that can be a . Some , like the one developed by Nobel Prize–winning economist , attempts to predict the future superiority of stocks versus bonds (or vice versa), have been published in
journals and are publicly accessible.
Market timing often looks at
such as 50- and 200-day moving averages (which are particularly popular). Some people believe that if the market has gone above the 50- or 200-day average that should be considered bullish, or below conversely bearish. Technical analysts consider it significant when one moving average crosses over another. The market timers then predict that the trend will, more likely than not, continue in the future. Others say, "nobody knows" and that world economies and stock markets are of such complexity that market-timing strategies are unlikely to be more profitable than buy-and-hold strategies.
Moving average strategies are simple to understand, and often claim to give good returns, but the results may be confused by hindsight and .
Perhaps consistent with these two opposing views is that, as with any type of trading, market timing is difficult to carry out on a consistent basis, particularly for the individual investor unschooled in technical analysis. Retail brokers are also generally unschooled in both the mindset and the tools needed to successfully time the market, and indeed most are actively discouraged by the brokerages themselves from moving their clients in and out of the market. However, as , many of these same brokerages take the opposite approach with their large institutional clients, trading various financial instruments for these clients in an attempt to "predict future market price movements" and thereby make a profit for the institutions.
This dichotomy in the treatment of institutional versus retail clients can potentially be controversial for the brokerages. It may suggest for example that retail brokers and their clients are discouraged from market timing, not because it does not work, but because it would interfere with the brokerages' market maker trading for their institutional clients. In other words, retail clients are encouraged to
so as to maintain
for the institutional trading. If true, this would suggest a conflict of interest, in which the brokerages are willing to sacrifice potential returns for the smaller retail clients in order to benefit larger institutional clients.
The 2008 decline in the markets was instructive. While many retail brokers were instructed by their brokerages to tell their clients not to sell, but instead "look to the long term", the market makers at those same brokerages were busy selling to cash to avoid losses for the brokerages' large institutional clients. The result was that the retail clients were left with huge losses while the institutions fled to the safety of short-term bonds and money market funds, thereby avoiding similar losses.
Regarding ,
announced on 8 July 2013 that it was suspending its early release practice as part of an agreement with the New York Attorney General's office.
A major stumbling block for many market timers is a phenomenon called "", which states that given set of trading rules has been over-optimized to fit the particular dataset for which it has been back-tested. Unfortunately, if the trading rules are over-optimized they often fail to work on future data. Market timers attempt to avoid these problems by looking for clusters of parameter values that work well or by using out-of-sample data, which ostensibly allows the market timer to see how the system works on unforeseen data. Critics, however, argue that once the strategy has been revised to reflect such data it is no longer "out-of-sample".
Several independent organizations (e.g., Timer Digest and Hulbert Financial Digest) have tracked some market timers' performance for over thirty years. These organizations have found that purported market timers in many cases do no better than chance, or even worse. However, there were exceptions, with some market timers over the thirty-year period having performances that substantially and reliably outperformed the general stock market, such as ' , which allegedly uses
developed by .
A recent study suggested that the best predictor of a fund's consistent outperformance of the market was low expenses and low turnover, not pursuit of a value or contrarian strategy. However, other studies have concluded that some simple strategies will outperform the overall market. One market-timing strategy is referred to as Time Zone Arbitrage.
flows are published by organizations like
and . They show that flows generally track the overall level of the market: investors buy stocks when prices are high, and sell stocks when prices are low. For example, in the beginning of the 2000s, the largest inflows to stock mutual funds were in early 2000 while the largest outflows were in mid-2002. It is good to note that these mutual fund flows were near the start of a significant bear (downtrending) market and bull (uptrending) market respectively. A similar pattern is repeated near the end of the decade. Chien of the
confirms the correlation showing return-chasing behavior.
This mutual fund flow data seems to indicate that most investors (despite what they may say) actually follow a buy-high, sell-low strategy. Studies confirm that the general tendency of investors is to buy after a stock or mutual fund price has increased. This surge in the number of buyers may then drive the price even higher. However, eventually, the supply of buyers becomes exhausted, and the
for the stock declines and the stock or fund price also declines. After inflows, there may be a short-term boost in return, but the significant result is that the return over a longer time is disappointing.
Researchers suggest that, after periods of higher returns, individual investors will sell their value stocks and buy growth stocks. Frazzini and Lamont find that, in general, growth stocks have a lower return, but growth stocks with high inflows have a much worse return.
Studies find that the average investor's return in stocks is much less than the amount that would have been obtained by simply holding an index fund consisting of all stocks contained in the
For the 20-year period to the end of 2008, the inflation-adjusted market return was about 5.3%. The average investor managed to turn $1 million into $800,000, against $2.7 million for the index (after fund costs). More recent results show a bigger difference, but the investor beating inflation slightly.
Dalbar's studies say that the retention rate for bond and stock funds is three years. This means that in a 20-year period the investor changed funds seven times. Balanced funds are a bit better at four years, or five times. Some trading is necessary since not only is the investor return less than the best asset class, it is typically worse than the worst asset class, which would be better. Balanced funds may be better by reason of investor psychology.
While market-timing strategies are legal, the
(FINRA) has long frowned on the practice because it passes trading costs to long-term investors. Consequently, many brokerages will not fill market-timing orders.
often agree that investors have poor timing, becoming less
when markets are high and more risk averse when markets are low. This is consistent with
and seems contrary to the
explanation. Academic theory assumes that investors are like Mr.
of Star Trek. In fact, most investors cannot process information like Mr. Spock.
"The only problem is that, unlike Mr. Spock of
fame, humans are not entirely rational beings."
Proponents of the
(EMH) claim that prices reflect all available information. EMH assumes that investors are highly intelligent and perfectly rational. However, others dispute this assumption. "Of course, we know stocks don't work that way". In particular, proponents of
claim that investors are irrational but their biases are consistent and predictable.
in 1987, , G. William Schwert, and
wrote that an unexpected increase in volatility lowers current stock prices.
(TFP) Growth Volatility is negatively associated with the value of U.S. corporations. An increase of 1% in the
of TFP growth is associated with a reduction in the value-output ratio of 12%. Changes in uncertainty can explain
fluctuations, stock prices, and banking crises.
Stock market forecasting
In econometrics, a dynamic factor (also known as a diffusion index) were originally designed to help identify business cycle turning points.[1]
Measuring Economic Policy Uncertainty
Pruitt, George, & Hill, John R. Building Winning Trading Systems with TradeStation(TM), Hoboken, N.J: John Wiley & Sons, Inc. , p. 106-108.
(2004) Can predictable patterns in market returns be exploited using real money? Journal of Portfolio Management, 31 (Special Issue), p.131-141.
Shen, P. Market timing strategies that worked — based on the E/P ratio of the S&P 500 and interest rates. Journal of Portfolio Management, 29, p.57-68.
Dumb money: Mutual fund flows and the cross-section of stock returns. by Andrea Frazzinia, Owen A. Lamont. University of Chicago, Graduate School of Business & Yale School of Management. Journal of Financial Economics 88 (–322. Page 320, paragraph 2
. MarketWatch.
Jim Cramer's Getting Back to Even, pp. 63-64
Expected Stock Returns and Volatility by Kenneth R. French, G. William Schwert and Robert F. Stambaugh
Risk, Economic Growth and the Value of U.S. Corporations by Luigi Bocola and Nils Gornemann
Understanding Uncertainty Shocks by Anna Orlik and Laura Veldkamp
: Hidden categories:Risk is an extremely important aspect of investing in bonds or any other financial instrument.
The effectiveness of a particular investment strategy can’t be determined just by looking at the rate of return.
The amount of risk inherent in that strategy must also be taken into account.
A 5% annual return for an investment strategy that takes very little risk, may be an attractive return, but a 5% return on a high-risk strategy would not be considered an acceptable rate of return.
The risk-adjusted return measures the rate of return for a portfolio or investment based on the amount of risk.
There are several types of risks that apply to bonds and understanding those risks will help you become a more skilled investor.
Interest Rate Risk
Changes in interest rates have a profound effect on bond prices.
This relationship is converse:
When interest rates increase, bond prices decrease
When interest rates decrease, bond prices increase.
This is often driven by the government using fiscal policy and/or the Fed using monetary policy to influence the growth rate of the economy and inflation. Interest rate risk also plays a major role in other bond related risks.
Interest rate risk does not affect all bonds equally.
Longer maturity bonds will experience a greater change in price than shorter maturity bonds for a given change in rate.
Lower coupon bonds will fluctuate more than higher coupon bonds.
Long-term zero coupon bonds experience the greatest price volatility when interest rates change.
Active bond traders looking to profit from changes in interest rates will seek out bonds whose interest rate sensitivity matches their particular strategy (usually they will seek higher sensitivity).
Credit or Default Risk
The second most significant risk for bond investors is credit risk.
Because credit risk is the risk that an issuer will default on payments of interest and principal, it is also referred to as default risk.
A bond issuer does not have to default, however, for credit risk to affect investors.
If one or more credit rating agency downgrades a bond issue (or the market has a perception this may happen), the price of a bond will drop.
The rating agencies will modify their ratings for several reasons including:
Changes in the economy
An issuer’s industry
The financial and competitive standing of the
individual issuer
Anything that will impact the issuer’s ability to meet
the financial obligation to bondholders including their ability to service
their debt
Positive changes can result in an issuer’s ratings being upgraded. Many bond traders speculate by buying bonds of issuers that they think may be on the verge of a ratings upgrade. A downgrade does not necessarily mean an issuer is close to default, and a change of one level may not necessarily result in a significant price change for highly rated issuers.
However, bondholders should view this as a warning sign and carefully monitor the company for possible further deterioration.
A downgrade that reduces an investment grade bond to non-investment grade can be particularly problematic.
Many institutional investors are required to hold only investment grade bonds.
If a bond that these institutions hold is no longer investment grade, they will be forced to sell the issue.
Because of the large positions these institutions usually hold, this selling can cause significant downside pressure on the bond’s price.
Also a downgrade of more than on level can have a significant impact on the bond’s price.
Reinvestment Risk
Reinvestment risk is strongly influenced by changes in interest rates.
When a coupon payment is received, the funds will be reinvested at current market rates. This rate may be more than, less than or equal to the coupon rate.
If the payment is reinvested at a rate lower than the bond’s yield, the investor will experience a lower total rate of return.
Of course a higher rate of reinvestment will result in a higher total rate of return.
It is the uncertainty of the ultimate rate of return that constitutes reinvestment risk.
The risk that rates may be lower than the bond’s yield to maturity at some point in the life of the bond is of concern to bond investors. Longer-term bonds make more coupon payments than shorter-term bonds, so there will be more reinvestment during the life of the bond.
Also, the longer the maturity, the greater the chances that lower bond rates may be experienced during the life of the investment.
Therefore, longer-term bonds are more susceptible to reinvestment risk.
Inflation Risk
(Also known as purchasing-power risk)
Inflation risk is the risk that general prices will rise, thus reducing the purchasing power of the future dollars received.
This results in a rise in interest rates as investors require higher returns for deferring their purchases to the future when prices will be higher.
Rising interest rates leads to lower bond prices.
Early Redemption Risk
(Also known as call risk)
Early redemption risk is also associated with interest rate risk.
Many U.S. agency, municipal, and corporate bonds are subject to early redemption, and all mortgage-backed bonds pay principal prior to maturity.
U.S. Treasury securities are no longer being issued with call provisions.
An imbedded call option is the equivalent of buying a bond and selling a call option on the bond to the bond issuer.
Because it is the issuer’s option to call back the bond, they will do so when it’s to their advantage.
This will be when interest rates are low and they can refinance at lower rates and reduce their cost of capital.
This is usually when the bondholder doesn’t want the bond called away, as they will have to reinvest at lower rates.
Having a bond called is not always a bad thing for an investor.
If a bond was purchased at a discount and is called at par or premium within a short period of time, the investor may experience an attractive total return.
However, bonds purchased at a premium would result in a loss of some principal if called at par or a lower premium.
Because of this call risk, callable bonds trade at a discount, or yield spread, to equivalent non-callable or bullet bonds.
This can make callable bonds an attractive investment for investors who don’t believe that interest rates will drop in the foreseeable future.
Many bonds offer a period of call protection, which means the bond is not callable until some date in the future.
Typically, such bonds will be initially callable at a premium.
This premium will decline with each subsequent call date until it eventually reaches par.
The complicated nature of call (and sinking fund) provisions makes callable bonds more complicated to analyze than bullet bonds.
It is important to analyze yield to worst when considering bonds with early redemption provisions.
Prepayment Risk
Prepayment risk is the early redemption risk associated with mortgage-backed bonds.
As homeowners are aware, monthly mortgage payments consist of both interest and principal.
This means that the principal is paid off monthly over time, rather than at maturity like a bullet bond.
Because mortgage-backed securities (MBSs) consist of pools of mortgages, prepayment risk is inherent to mortgage-backed bonds.
Some homeowners may prepay their mortgages in order to move to a new house or to refinance their current mortgage. This will accelerate the prepayment rate of a MBS and shorten its maturity.
This is known as contraction risk. Like bond issuers, homeowners will refinance their mortgages when interest rates decline.
Unlike callable bonds, however, not all homeowners will refinance, and they will not all refinance at the same time (some homeowners may hold off if they think interest rates will decline further.)
There are a number of reasons for homeowners to prepay their mortgages:
Upgrading their home
Downgrading their home if they experience financial
difficulty
Employment relocation
Retirement
This makes contraction risk very difficult to anticipate, though some MBS investors employ sophisticated analysis of the regional demographics and economic conditions of individual pools of mortgages in order to more accurately assess contraction risk.
Some homeowners choose to pay back their mortgage early by including an additional amount of principal with their monthly mortgage payment.
This is early accelerated prepayment is known as curtailment but is not a significant factor for most MBSs.
When interest rates rise, mortgage holders have no incentive to prepay their mortgage if they don’t have to.
This is known as extension risk, as it extends the life of an MBS.
MBS investors can never be sure of the actual yield to maturity they will experience because the actual life of the bond is not known.
The investment decision is based on an expected life and yield to maturity.
Investors that purchase MBSs at a discount would prefer the life of the bond to be shorter, as this will mean their capital gain occurs sooner, and this will increase their yield to maturity.
Investors who purchase their bonds at a premium, would prefer that the life of the security will be longer than expected.
Investors that bought at a discount, welcome contraction and fear extension.
Investors that bought at a premium welcome extension and fear contraction.
Event Risk
This is the risk that a significant event will seriously impact an issuer’s credit rating and ability to repay their debt obligations.
This most often happens as the result of a leveraged buyout, merger, recapitalization or other corporate restructuring that greatly increases the issuer’s debt load and stretches its financial resources. This makes it vulnerable to an economic or business downturn.
Less often, event risk can also result from natural disasters, industrial accidents or even acts of terrorism.
Liquidity Risk
Liquidity risk is the risk that a seller will not be able to find a buyer for their bond, or will have to sell it at a substantial discount to attract a buyer.
This usually occurs with:
Small issues of bonds
Lesser-known issuers that do not come to market often
Lower rated or downgraded issues
With tens of thousands of bond issues available to investors, not all issues are going to be familiar to most investors.
This problem is exacerbated by the fact that very few bonds trade on organized exchanges and the vast majority trade over-the-counter between dealers.
Most bond trades occur in round lots of $100,000 or $1 million dollars.
Smaller lots are referred to as odd lots and are much less liquid than the round lots.
Individual investors are more likely to trade in odd lots.
The recent economic crisis that resulted from the bursting of the housing bubble provides a perfect illustration of liquidity risk. The dramatic increase in the number of mortgage foreclosures caused a panic that virtually froze the markets for mortgage related securities.
Currency Risk
(Also known as exchange rate risk)
Currency risk occurs only when an investor purchases a bond that is denominated in a foreign currency.
The exchange rate between any two currencies is constantly changing due to such factors as the two countries’ relative balance of payments and level of interest rates.
If a U.S. investor purchases a euro denominated bond, his future payments of interest and principal are made in Euros.
Because the investor will have to exchange those Euros for U.S. dollars when they receive the payment in the future, changes in the dollar/euro exchange rate will affect how many dollars the investor receives in the future.
There is a risk that the investor will get back less dollars than they anticipated, which would adversely affect the actual yield to maturity that they will realize.
For example, if one euro is worth $2, a bond payment of 100 Euros will be worth $200.
If the euro strengthens relative to the dollar to be worth $2.50, that same payment will be worth $250.
So investors that purchase bonds denominated in a foreign currency hope that the currency increases in value relative to their home currency.
The risk to U.S. investors is that the currency weakens and the investor is paid back with fewer dollars.
Political Risk
(Also known as country or sovereign risk)
Political Risk is associated with the government or corporate debt of countries that have an unstable government.
This is most often found with lesser-developed and emerging market countries.
The risk to corporate bonds comes from the risk of the government seizing the assets of a bond issuer by privatizing certain companies or industries.
There is also the risk that an administration may default on government debt, especially if there is a coup or other change in leadership.
Some investors are attracted to the risk and potential high rewards from speculating in the debt of emerging economies because of the high rate of interest that such issues have to pay to attract capital.
Some bond traders and investors specialize in speculating in the issues of especially troubled regimes, but this is not for the faint of heart!
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