Those who criticize market timing don’t understand what market timing really is. Market timing, to be clear, is NOT—I repeat NOT about having the clairvoyant ability to predict exact peaks and troughs. BTW- If any reader believes they possess an unfailing ability to predict market peaks and troughs, please forward your resume to me immediately with proof. I will either hire you and start you at $1MM salary (plus lots of bonus incentive) or– I will have a nice man in a white coat come to visit you and take you away. Likely the latter.
Market timing is not about picking peaks and troughs. That’s called crystal ball prognosis, or owning a time machine. I own neither a crystal ball nor a time machine. I do, however, “own” some tools to analyse risk vs. reward potential. I can quite accurately, using historic data, show you when risk is higher or lower than historic norms on a stock or a market. And I do this type of risk analysis pretty accurately most (not all) of the time. Market timing—REAL market timing that is, is about recognizing that markets ALWAYS have risk, and ALWAYS have reward potentials simultaneously. A good market timer will simply decide to overweight or underweight their exposure to a market according to that degree of risk vs. potential return. I’d like to take a look at a few of the tools I use to assess risk and reward. This list is not all inclusive—I will focus on a few of the more interesting ones today. We’re focusing on the broad US market factors that I like to look at.
This is a measurement of option premiums. The more premiums being paid, the more volatility option traders are anticipating. Historically, when the VIX gets near 10—its “too quiet”. If it’s around 35—traders are “too worried”. Right now, they are too worried. That’s good. The chart below shows this tendency since 1996—market don’t like to hang out at the top end of this band for too long…
Put to call ratio
Investors normally prefer call options (the right to buy a stock at a certain price and date) over put options (the right to sell a stock at a certain price and date). That’s because normally markets are bullish/trending up. When put volume exceeds call volume—as it is now, it is a sign of capitulation. Everyone wants to hedge their stocks or make a bearish bet after the market has already fallen—and it’s too late to do so. We’re at the top of the put/call historic ratio range. This is a contrarian sign of markets getting ready to bottom.
Here’s about 20 years of data of NYSE stocks making new highs vs. those making new lows. This is a breadth—i.e. a market participation indicator. You can use it to see if there are not enough participants in the broad markets—that can give a warning sign when markets are too focused on one or two sectors—such as in 1998 (tech stocks), 2007 (energy, real estate). That’s a heads up for bad stuff to come – note the low levels of this indicator near the bottom of my range-lines in both of those periods. But you can also look at this indicator to note if things are getting too oversold. Obviously in a market crash, you will get less new highs vs. new lows on a broad basis. So it’s not a concentration problem—it’s a sign of mass-panic. And mass panic is good for us contrarians. We’re near that point on my noted range lines. The Beatles sang: “It’s getting better all the time!”. Risk is shrinking.
And finally…my favorite indicator!
Somebody wrote me an email a month ago asking me to stop using the term “dumb money” when referring to retail investors. Well, I was sorry to tell this person that the terms “smart money” and “dumb money” were not created by yours truly. It’s been a tool used in technical analysis for a long, long time. And I think it’s a great term.
BTW—we’re all dumb money. Unless you are managing a large pension fund, or a sophisticated commercial hedger, or Warren Buffett/George Soros/ Bill Ackman—you are likely in the dumb money category. Take heart, I am too! So let’s just acknowledge our dumbness, and then use that knowledge to fight our natural emotional tendencies to buy high and sell low. Let’s follow the smart money. And right now—the smart money is BUYING!!!!!!! Meanwhile—dumb money (not you and I of course) is SELLING!!! This is the single best thing we can see as a sign of good times to come. The chart below, courtesy of www.sentimentrader.com, shows us the level of smart investor confidence is soaring with a 90% confidence level—something rarely seen except at market bottoms – meanwhile the dumb money confidence level is plummeting—only 29% of your local unsophisticated investors likes equity!
So go ahead, tell that neighbour (preferably one who you don’t care for) that he should keep selling his mutual funds now that markets are low. It’ll finish washing out the market when he’s all out, and then you and I can step in – along with the smart money. We’ll buy the cheap stocks his fund manager had to sell to meet his redemption. Sometimes I love this business!