Sunday, February 08, 2009

Minding Medium-Term Methods

Successful medium-term market timing requires some mental discipline - more, I believe, than either buy-and-hold or day-trading methods.

At one end of the investing spectrum, the successful long-term buy-and-hold investors are the ones who just don't care. These folks will often choose their 401(k) funds when they start their careers, and then they may never look at them again until they retire. This is not necessarily mental discipline on their part, but can simply be a lack of interest. The problem occurs when a buy-and-hold investor starts to pay attention, because then he may cash out near the bottom of bear market, only to miss out on the turn-around rally.

At the other extreme are the day traders. If buy-and-hold types ignore the stock market, day-traders eat, drink and breathe it. You might even say they drown in it. I realize that a few day traders may beat the market in the long run, but by definition most of them will not. Besides racking up trading fees and paying short-term capital gains taxes, I think day traders are prone to lose sight of obvious and important long-term trends; they don't see the forest for the trees, as the saying goes.

If buy-and-hold investors don't need any discipline, I think day trading actually results from a lack of it. In the most extreme case, a day trader is someone who sees a torrential flood of minute-by-minute market data, and determines that he should take in as much as possible in order to make as many trades in as little time as possible. Following this logic, more data is better, and profit increases the more one trades. I sometimes get comments and e-mails from people who have concerns about a single day's rise or fall in the stock market, and I think they risk falling into this trap.

My method lies in-between these two extremes. At the very least, I aim to be invested in stock funds during bull markets, and in bear funds during bear markets, so that I can make money in both directions. A perfect longer-term market-timing method would have followed the black arrows in this 8-year S&P 500 chart:

The highest effort I'll expend is to jump in and out of funds in order to take advantage of multi-month cycles of rally and retreat, illustrated by the blue arrows.

I say that this method requires more discipline because, unlike long-term investors, I have to pay attention to the stock market; and unlike day traders, I have to resist being overwhelmed by the data and making short-term decisions based on every wiggle in the charts. I don't claim to be a perfect practitioner by any means, but I'm always trying to anticipate how my own human failings might sabotage my efforts.

9 comments:

vv said...

Loved the latest series of posts!

Have you explored (based on past data) the returns on your medium term strategy as compared to buy-and-hold and dollar-cost-averaging strategies? If so, could you share them with us?

By the way, did you see this in the S&P earnings excel file? "Throwing in the kitchen sink, refrigerator, washer,… need to remodel kitchen but no refinancing available" :)

One more question, do you create the nice looking graphs with the trend lines in yahoo finance? Or do you create them by adding lines to the yahoo charts in an imaging software?

Thanks!
Vin

Jody said...

I'm still working on a mechanical model that can back-test the returns of my method over many years.

Regarding the S&P data, yes, it's good to see that even the folks at Standard and Poor's can have a little fun during bad times.

I use Paint Shop Pro to add lines to yahoo! charts.

jeff said...

Jody,

I am sure you must be constantly reviewing and refining your methodology. What are some parameters you have recently added or deleted as useful or not? How do you direct your search for possible new ingredients to your recipe?

I love your blog...keep those posts coming!

Thanks, Jeff

Jarrod said...

Jody,

Saw this article on NYTimes.com titled,"Why analysts keep telling investors to buy".

Thought it might fit into the contrarian/market sentiment theme.

http://www.nytimes.com/2009/02/09/business/09analyst.html?_r=1&ref=business

Thanks for the informative blog.
Jarrod

vv said...

Jody,

Check out the new earnings numbers from the S&P website.. They've worsened since last time. With 79% now reporting, future P/E for the 2nd Q 2009 based on today's close is around 42!! I wonder if companies are deliberately downgrading earnings expectations so that they can 'beat the estimates'. The earnings estimates quickly seem to recover after the 2ndQ 2009.

Jody said...

Jeff,

My point at the end of this post was not so much about looking for new market indicators (which I do from time to time), but about making sure that I read what the indicators are actually telling me, rather than what I wish they were telling me.

Jarrod,

You're absolutely right - the only use for analysts as a group is as a contrarian indicator. When in doubt, go against the herd.

Vin,

A P/E of 42! I never thought I would witness valuations like that again. The downward revisions just keep coming, and the P/E is still forecast to be 19 in the first quarter of 2010.

Jarrod said...

Here is another great article about Newsletter Advisers unfazed by Thuesday's carnage.

http://www.marketwatch.com/news/story/story.aspx?guid=%7B61E3F35E%2D9D69%2D4AF8%2D8246%2DC75DF4B8CB01%7D

Jarrod

vv said...

The numbers got even worse, with 85% now reporting, the EPS losses for 4Q 2008 was -$10.44. This is up from -$3.44 the last time you posted the link to the site, which was then 65% reporting. The P/E estimates for the 2nd and 3rd Q of 2009 using the current price of 835 are at upper 50's . Yet the operating P/Es never rise beyond 20. Why is that? In the 2000s when the as reported P/Es were in the mid 40's, the operating P/E was around 30. I wonder whether most companies are deliberately playing an 'expectations' game. Any thoughts?

Vin

Jody said...

Vin,

One way to think about Operating Earnings is this: It's what a company would earn assuming nothing bad happens. For example, it's what a bank would earn assuming 100% of mortgage payments are made from here on out. Or, it's what an insurance company would earn assuming that Florida never has another bad hurricane season. So, when a large fraction of home owners stop making payments, or when Florida gets hit by four large hurricanes, then real earnings and operating earnings become widely separated.