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Stock Market Timing

Market Timing Case Studies

Stock Market Timing Works: Case Studies


Market Timing Concept Using Mutual Funds - The Basics

The basis for timing the stock market and mutual fund switching derives from the fact that ideally one should be invested in the stock market when prices are rising and out of (or short) the stock market when prices are falling. This is easier said than done and most mutual fund and brokerage houses will tell you it cannot be done successfully. However, contrary to what many would have you believe, there are those who ARE SUCCESSFULLY "timing" the market and it is prudent for disciplined investors to follow the advice of these market gurus.

There are two advantages to timing the market. First, returns can be substantially increased by only being in the market when it is rising and out of (or short) the market when it is falling. Second, you are in a much safer position by being out of the market during potential market declines because one never knows how far a decline might take us. Recent history tells us that the market always recovers from declines and eventually makes new highs. However, a longer look at historical price movements warns us that at any time a perilous market decline could happen wiping out as much as 80% of market assets. It could be in the form of a market crash or, more likely, it could be a slower oscillating decline taking many years.

The Japanese stock market, one of the hottest markets in the 80's, recently reminded us of the perils of the "buy and hold" strategy. The Japanese market peaked at the end of 1989 and fell a whopping 67% through the late 1990's. Nearly a nine year bear market! Be aware that the US stock market is not immune to a similar fate given the right circumstances.

On the other side of the coin, there are also some disadvantages to timing the market. First, unless you are timing the market in a tax deferred vehicle such as an IRA, your gains will be taxable in each year that you take profits and move out of the market. A buy and hold approach will defer taxes on gains until you sell your stock (however, mutual funds may pass profits and losses to share holders for tax purposes even if you don't buy and sell). Second, you or your timing advisor might guess wrong about the market direction and cause you to miss a large advance by being out of the market or maybe not get you out in time to avoid a large decline. And, third, you might be on vacation when you should be exiting the stock market! All of these disadvantages can be satisfactorily addressed with a little research and planning.

OK, so now that we know about the advantages and the disadvantages of timing the market, how do we go about doing it? Although there are several methods available to time the stock market, we are only going to address the use of mutual fund switching within a single family of funds. This method has several advantages. First, we can use a no-load fund family and avoid paying commissions when we wish to move into or out of the market. Second, the investment vehicles used to be "in the market", "out of the market" or "short the market" are available from many no-load mutual fund groups.

To keep our discussion brief, lets only discuss the Rydex family of mutual funds. Rydex has three investment vehicles that are ideally suited to timing the stock market. They have a fund called the Nova Fund that attempts to move exactly in proportion to the Standard & Poors 500 Index. The ratio the Nova Fund tries to move in relation to the index is 1.5 to 1 (also called a beta of 1.5). That means if the S&P 500 Index rises 1%, the Nova Fund would probably RISE 1.5%. And, if the S&P 500 Index falls by 1%, the Nova Fund would likely FALL by 1.5%. So we can use the Nova Fund as our "in the market" vehicle.

The Rydex family also has a money market fund where we could move our money to the safety of an interest bearing non-price-fluctuating account similar to a savings account. For those not wishing to be "short" the market when it is falling this is the investment vehicle of choice during market declines. We will use the Money Market Fund as the "out of the market" vehicle.

The third fund at the Rydex family we could use would be the Ursa Fund. The Ursa Fund is a new breed of mutual fund that moves inverse to the stock market. What this fund attempts to do is move up when the market is falling and move down when the market is rising. It accomplishes this by using short sales of stock and market derivative products to earn money for the fund during market price declines. You don't need to understand the mechanics of this because the fund manager takes care of all that for you. The ratio that the Ursa fund tries to maintain is 1 to 1. This means that if the S&P 500 declines 1%, the Ursa fund will RISE by about 1%. And if the S&P 500 rises by 1%, the Ursa fund will FALL by about 1%. We will use the Ursa Fund as the "short the market" vehicle (except in retirement plans where short positions are not allowed).

Now let's step through an example of how this all works using some round numbers and fictitious dates to make it easy to understand.

Let's purchase $100,000 of the Rydex Money Market Fund to start our investment on December 1, 2009. Rydex sends us a confirmation of our purchase and gives us an 800 number to call and/or an on-line site to make exchanges to other funds in the Rydex family of funds. Our money is earning money market interest while we wait for the next buy or sell signal from our timing advisor.

Suppose that at the close of trading on December 31, 2009 our advisor issues a "BUY" signal. We then call the trading desk at Rydex on the next trading day, January 2, 2010, and instruct them to move $100,000 from the Money Market Fund to the Nova Fund. The S&P 500 Index on that date is 1000 and 10,000 shares of our fund are purchased at $10.00.

Four months later, on April 30, 2010, our timing advisor issues a "SELL" signal. We again call the Rydex trading desk on the next trading day, sell our Nova fund and purchase the Ursa Fund with 100% of the proceeds. The S&P Index has risen to 1500, the Nova fund is sold at $17.50 (1.5 to 1 ratio) and we purchase the Ursa fund at $10.00. We can now purchase 17,500 shares of the Ursa Fund because of the profits we have made so far in the Nova Fund. (Those not wanting to short the market would purchase the Money Market Fund instead of the Ursa Fund.)

Over the next eight months the S&P 500 Index works it way down and finishes the year at 1100. Our Ursa fund rose as the market fell and finished the year at $12.66 (a 26% decline in the S&P 500 translated into a 26% gain in the Ursa fund).

Now lets make a table and compare our results with that of a buy/hold approach. Let's assume for the buy/hold comparison that we bought the Nova Fund on January 2nd and held it for the entire year.

Market Timing Concept Example *
Date S&P
Timing Signal Buy/Hold
Nova Fund Value
Timing Value
01/02/2010 1000 BUY Nova $10.00/share $10.00 x 10,000 shares = $100,000
05/01/2010 1500 SELL Nova $17.50/share $17.50 x 17,500 shares = $175,000
05/01/2010 -- BUY Ursa -- $10.00 x 17,500 shares = $175,000
12/31/2010 1100 Hold Ursa $11.50/share $12.66 x 17,500 shares = $221,500
Total Gain 100 -- $1.50/share $121,500
10% -- 15% 121.5%

* Note: The above example uses fictitious dates and exaggerated prices
to help make the timing concept easier to understand.

You can see in the table that by correctly timing the market movements we were able to significantly out perform the buy and hold investor. However, because we used large moves in the market to make our example easy to follow, the timed return is unusually high. The stock market normally does not rise 50% then fall 26% in one year. This is merely an example of how the market timing concept works. Also, one might have just moved to the safety of the Money Market Fund instead of purchasing the Ursa Fund during the market decline and profits would have only been $75,000 or a 75% percent return plus some interest earned in the Money Market Fund.

The Buy/Hold investor also beat the S&P 500 Index because of the 1.5 to 1 ratio of the fund to the index. Had the market fallen by 10% for the year, the Buy/Hold investor would have lost 15% instead and our market timing results would have earned even more.

Keep in mind that our example is exaggerated to enable us to explain the concept. Returns this high are not common place.

You now have an understanding of how the timing concept works. You only need now to find an advisor with a track record of out performing the market indexes and you will be able to make profitable switches in your mutual fund family as signals are generated. It is wise to compare the signal performance of several advisors over the last few years through both up and down market cycles before making your choice.

I hope this information helps to guide you to a safer and more profitable investment vehicle for your equity assets.

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