When Does Market Timing Work?

On the Necessary Conditions for Successful Market Timing

sand dune in desert being blown by sand with people walking along its ridge
Photo: Luca Zanon on Unsplash

I know you have probably heard it all before:

You can’t time the market.  Give up.  It’s too hard.

While I don’t disagree with this advice, it doesn’t actually address what conditions you would need to meet in order to be a successful market timer (without using quantitative approaches).  So instead of writing off market timing, let’s ask, “When does market timing work?”

I looked into this, using the S&P 500 (with dividends) since 1990, and discovered that to succeed as a market timer you would have to:

  1. Know when the market is about to decline by some threshold amount (i.e. 20% or more).
  2. Act on this knowledge by selling within 250 trading days (1 year) of the top and re-buying within 250 trading days of the absolute bottom.

If we generalize this, successful market timing requires the ability to anticipate future declines and to act on them within a reasonable time frame.  It doesn’t mean that you have to know exactly when the top/bottom is, but it does mean that you need to have a general sense of the market’s direction in the near future.

While this conclusion might seem obvious to you, what isn’t obvious is how much you can miss the top/bottom while still outperforming Buy & Hold.  So, let’s dig in to find out.

To start, we will assume that you are invested in the S&P 500 and you never want to lose 20% (or more) of your money.  This implies that you needed to miss the two major crashes (Dot Com Bubble and GFC) that have occurred since 1990:

the s&p 500 from 1990 to 2019 with every 20 percent drawdown being highlighted With perfect timing, you could have avoided these crashes by selling at the top, moving to cash and then re-buying at the bottom.  If you had done this perfectly, $1 invested in 1990 would have grown to $64 (excluding inflation, taxes, and transaction costs), compared to only $15 for Buy & Hold (note the log scale on the y-axis):

buy and hold vs market timing for the s&p 500 since 1990 with no timing lagThe blue line in the chart above represents our timing model where you miss the top/bottom by 0 days (i.e. perfect timing).  Of course, perfect timing is impossible.  So let’s now do the same thing, but assume you miss the top and bottom by 60 trading days (~3 months):

buy and hold vs market timing for the s&p 500 since 1990 with a 60 day timing lag

In this instance, your $1 invested in 1990 would have grown to $31.  This still beats Buy & Hold’s performance, where $1 grew to $15, but it is far below the perfect timing model.

As we continue to extend the number of trading days by which you miss the top/bottom, market timing continues to lose its performance edge.  By the time you miss the top/bottom by 250 trading days (1 year), market timing actually starts underperforming Buy & Hold:

buy and hold vs market timing for the s&p 500 since 1990 with a 250 day timing lag

As you can see, selling 1 year after the top and buying 1 year after the bottom has similar performance to Buy & Hold.

But, I don’t just want to show snapshots.  The chart below illustrates how market timing loses its performance edge as the number of days missed from the top/bottom increases.  This decline in outperformance happens quickly and then more slowly as the number of days missed from the top/bottom grows larger.  Additionally, I have also broken this relationship down by drawdown size (20% vs. 10%) to show that market timing has greater outperformance when avoiding larger declines:

market timing performance relative to buy and hold based on the number of days missed from top/bottom

The main takeaway is that the more quickly you can avoid larger drawdowns, the more you will outperform Buy & Hold.  In addition, this plot illustrates just how small of a benefit market timing provides when executed imperfectly or on smaller drawdowns.

For example, missing a 10% drawdown by 60 trading days (3 months), only provides outperformance of 5% (on average) relative to Buy & Hold.  Spending time and energy on such an endeavor may not be worth the hassle, especially if you are wrong.

Lastly, there is one huge issue with market timing that I have ignored for this entire article.  How do you know when a market decline will be 20% (or greater) before it happens?  You don’t.  You have to go off some feeling that this decline is “the big one” and not one of the smaller declines that happen more periodically.  Just look at this plot which alternates between the 10%+ drawdowns and the 20%+ drawdowns in the market since 1990:

gif showing the tops and bottoms of the s&p 500 for 10% and 20% drawdowns

How would you be able to differentiate between the 10% declines and the 20% declines beforehand?  You could try to use valuation (i.e. P/E), but the evidence suggests that these are hard to use in real time and only work in the extremes.  This leads me to the same conclusion as my colleague Ben Carlson: Market timing is hard.

In addition, my conclusion that you could miss the top/bottom by up to 250 trading days and still outperform Buy & Hold is based on…wait for it…two observations!  Though I agree that there isn’t enough data to make specific conclusions like this, it does illustrate how its possible to outperform even if you miss the top/bottom by months.

Market timing isn’t impossible, but to do it successfully you need to be reasonably accurate on the market’s future direction.  Just because you called a top/bottom this time doesn’t imply that you will call the next one.  Things change and your way of gaining insight may no longer be valid in a different investing environment.  Keep this in mind before you attempt any form of market timing.


The Only Way to Time the Market

Though I don’t believe that most individuals can time the market on a consistent basis, the data suggests that using a quantitative, rules-based approach to market timing can yield positive results.  I didn’t used to believe this, but after reading Corey Hoffstein’s piece on two centuries of momentum, Meb Faber’s white paper on tactical asset allocation, and EconomPic’s post on trend following I became convinced by the evidence.

Why do these kind of timing strategies work in the long run?  Because they fail a lot.  They have false positives and this makes them difficult for many investors to stick with.  I have written about this before if you want to a test the waters, but I still recommend doing a lot more research before embarking on a market timing strategy.

Lastly, a special thanks to Michael Batnick for heavily inspiring this post and thank you for reading!

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This is post 123. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

 
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34 Responses

  1. Anonymous commented on May 07

    The best info i have ever seen on mkt timing. SOOO much work went into this simple article. (BTW: I have a huge amt of my portfolio in cash, waiting for the bottom, so if anything, i am timing the mkt.)

  2. Anonymous commented on May 07

    Nice article Nick. I do think that most people would take a broad asset class perspective when timing or tactically adjusting a portfolio. It is hard to conclude that any system is good enough to avoid drawdowns but profitably shifting around different sub-asset classes (stocks, bonds, commodities, fx/cash) is a much lower bar. You won’t be able to avoid say equity risk but different asset sub-groups do have different levels of exposure. Just a thought.

  3. Anonymous commented on May 07

    The 1990+ timeframe you’ve shown has ample data to study a stocks/bond/cash periodic rebalancing per some rules-based threshold which someone as talented as you could explore in a future related post.

    It is my belief that diversified asset class rebalancing is a close cousin to market timing. Rebalancing is almost always superior to buy and hold on drawdowns and usually only falls slightly some of the time below buy and hold depending on the circumstance. In effect it has a higher upside to downside capture ratio. And, it allows the investor to take more equity risk at times and stick with the plan long term.

  4. Anonymous commented on May 07

    Nice article. What if instead of focusing on highs and lows, one would focus on average-to-date: buy when bellow and sell when above?

  5. Anonymous commented on May 07

    While this finding may benefit an index investor, it becomes more complicated when you think about an individual investor’s portfolio. Then we may have to delve into the correlations between the market and the portfolio, not to mention the frictional costs involved in getting in and out of position frequently. I suppose when you frame the question this way, the data may point more prominently towards why market timing, while not necessarily a terrible idea, ultimately doesn’t offer much by way of rewards to the long term investor.

  6. Anonymous commented on May 08

    There are other methods of managing risk that minimizes the need to time the market.

  7. Anonymous commented on May 10

    Interesting article. But it completely ignores, NOT whether you get it right… but all the times when, IN ADDITION TO GETTING IT RIGHT, you get it wrong on separate occasions. There is so much more to discuss that, sadly, all the missing material simply contributes to the times when you get it wrong rather than whether and how you get it right. Timing the market? Can’t be done. Sorry.

    • Nick Maggiulli commented on May 10

      Agree with your logic, but the article addresses this to some extent when discussing how it is difficult to discern between 20% and 10% drawdowns.

  8. Anonymous commented on May 10

    Hello thanks for this informaiton. Its great.

  9. Anonymous commented on May 11

    If one takes into account large positions with large cap gains, it would take a very big correction to make it worthwhile to time the market. Federal, state,and Obamacare taxes can easily make that a 30-50% loss to be worthwhile.Then there is commissions, although those are not as costly.

  10. Anonymous commented on May 14

    Would appreciate the exact dates of the red and green dots.

    Sold June 2007 due to Hingenberg Omen Cluster that month and bought back mid March 2009. Think I timed that one pretty good.

  11. Anonymous commented on May 15

    Have you ever thought about using TA to try to improve market timing. Using simple MA trading rules but on weekly charts to test for various levels of the parameters. Or other forms of technical analysis.

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