More Proof Market Timing Doesn't Work

Posted: Feb 05, 2009 12:01 AM
More Proof Market Timing Doesn't Work

Investors have proven once again that market timing doesn't work and that the stock market is impossible to predict.

The first week of December was a wild ride for the Dow Jones Industrial Average. The Dow dropped 680 points on Monday, Dec. 1, then gained 270 points Tuesday and 172 points Wednesday, then dropped 215 points on Thursday before rising 259 points on Friday.

Thus, the Dow fell 7.7 percent on Monday but rose 6 percent from Tuesday to Friday. So, what's the point?

It's this: That Monday consumers sold $16 billion worth of stock mutual funds, according to TrimTabs Investment Research. Consumers then invested $4 billion back into those funds by Friday. In other words, they sold on Monday when the market dropped 7.7 percent and bought on Friday after the market had gained 6 percent.

They sold low and bought high.

Everyone knows the way to get rich is to buy low and sell high, but time after time, people make the mistake of doing just the opposite. They hear bad economic news and see a decline in the market value of their portfolio and they panic. They sell when they should be buying. They buy when they should be selling.

No matter how many times I warn that it's virtually impossible to correctly time the market, people ignore my words.

The way I see it, there are two kinds of investors: those who don't know how to engage in market timing, and those who don't know they don't know how to do it.

One of the reasons people make this mistake is because they don't realize the relationship between the economy and the stock market. In fact, many assume they are one and the same, but that's simply not true. Rather, the economy reflects the present state of the country's collective finances, while the stock market is a prediction of what the economy will do.

To explain it another way, the stock market is a leading economic indicator -- meaning stock prices reflect investor expectations of future corporate profits, not past or current.

It's important to understand this point. Unlike lagging indicators (which tell us what happened) and coincident indicators (which tell us what is happening), leading indicators tell us what is expected to happen. For example, "sales of new homes" is a lagging indicator (because it tells us how many homes were sold); "construction starts" is a coincident indicator (telling us how many homes are under construction); while "construction permits" is a leading indicator (telling us how many homes will be built in coming months). As a leading indicator, stock prices reflect investor sentiment about future corporate profits. Because the market tends to look six to nine months ahead, you shouldn't hop in and out based on current news.

This also explains why stock prices can be expected to rise before the economy itself improves. So even though the nation is in a recession, and even though the recession may last months, the stock market is likely to rebound before the recession is over.

But you'll miss that recovery if you're sitting on the sidelines making guesses about short-time fluctuations.

Don't play a game you can't win. You're more likely to win by staying invested.