Market timing works

            There is a widely held belief that there are lots of indicators that predict future market movements. Some of these indicators are crude but have popular appeal. A common example shows up every January around the time of the Super Bowl. If a team from the old American Football Conference wins the Super Bowl, you will be told, it will be a bad year for the stock market. Some are more sophisticated and follow economic logic. If markets are driven by the economy and interest rates, it seems logical that you should be able to use macroeconomic variables (such as the level of interest rates) to forecast what will happen to the market in the following period.  Still others are based upon extending measures that work for individual companies. If companies that trade at low multiples of earnings are cheap, then markets that trade at low multiples of earnings, relative to other markets or their own history, must also be cheap. Whatever the indicator, though, the underlying thesis is that it can be used to decide when to go into stocks and when to get out.

            Closely linked to these indicators is the assumption that there are other investors out there who are successful at market timers. This explains the attention that market strategists at investment banks attract when they come out with their periodic views on the right asset allocation mix; the more bullish (bearish) a strategist, the greater (lesser) the allocation to equities. This also explains why the dozens of investment newsletters dedicated to market timing continue to prosper.

            Why are so many investors willing to believe that market timing works? It may be because it is so easy to find market-timing indicators that work on past data. If you have a great deal of historical data on stock prices and a powerful enough computer, you could potentially find dozens of indicators (out of the hundreds that you try out) that seem to work. Using the same approach, most market timing newsletters purport to show that following their investment advice would have generated extraordinary returns on hypothetical portfolios over time.