Market Timing: There are only two types of investors

There are quite long periods when the market falls and takes a long time to regain previous highs. 

How shall we judge whether you should try to take advantage of this?



Market strategies:  Dollar Cost Averaging versus Absolute Bottom Buying Strategy

Dow Jones Industrial Average Index from 1970 - 2020.  This is a period of 50 years which spans inflationary and deflationary cycles and which has seen several crises and crashes as well as bull markets.  It seems like a long and fair sample period.

Imagine that over this 50-year period there are two competing investment strategies. 

1. One is to invest an equal amount every trading day throughout the period irrespective of market conditions - the so-called dollar cost averaging.
2. The other strategy requires enough foresight for the investor to invest the same amount daily, but to stop investing when the market turns down and save the cash.  This money is only invested when the Dow makes a new bottom, hitting its low point in any period of decline (hence why it is known as an "absolute bottom buying strategy").

This is a somewhat more realistic example of how you might apply foresight, rather than measuring what would happen if you had such certainty about the future you were able to sell everything just before the market turned down and then buy it back at the bottom.


Outcomes

Over the 50-year period, the second strategy would have produced returns 22 per cent higher than the first.

It sounds impressive - perhaps a little less so when you break it down to a 0.4 per cent outperformance per year 

But think of the time and effort you would have to spend monitoring markets to get those calls just right.



Possibly foregoing any significant gains

Since March 2013, the Dow is up just over 150 per cent in total, averaging 13.3 per cent per annum. 

Imagine if you had acted on market fears and taken your money out of equities or stopped investing ahead of that performance. 

Should you risk foregoing any significant portion of that gain for a maximum upside of 0.4 per cent per year.




Anticipation

Nobody has perfect foresight:  

• wrong about the events and 
• wrong about the market's reaction to events

In reality, attempt to implement the second strategy will almost certainly cause harm to your net worth as nobody has perfect foresight.  In your desire to time the markets, you will stop investing, or worse, sell and take money out when you expect the market to go down and instead it goes up.

Think back to Brexit and Trump's election.  We were told by most commentators that they wold not happen, but if they did, the markets would plunge.  Not only were they wrong about the events but they were also wrong about the market's reaction to events.  The markets soared.



There are only two types of investors

When it comes to so-called market timing, there are only two sorts of people: 

1. those who can't do it, and 
2. those who know they can't do it.  

It is safer and more profitable to be in the latter camp.

There is a lot to lose and little to gain from market timing.

Reference:  The Financial Times

There is a lot to lose and little to gain from market timing.

There is a lot to lose and little to gain from market timing.

When it comes to so-called market timing, there are only two sorts of people

1. those who can't do it, and
2. those who know they can't do it.

It is safer and more profitable to be in the later camp.



What is market timing?

With the Covid-19 pandemic dominating the news and recent volatility on world stock markets, you may have heard a lot about market timing again. 

Advisers and financial commentators will probably not use that actual term.  What they will talk about is whether you should sell some or all of your equity investments because of the economic effects of the coronavirus and the subsequent effect on the market.

All of this what is termed "market timing" in the jargon of the investment trade - holding back investment or taking some or all of your money out of the market when you anticipate a fall.



Problem of this approach:  Can you anticipate the markets?

The word "anticipate" indicates the first problem with this approach. 

Most people whom I encounter take their money out during or after a fall - as they did in March. 

[They are doing the equivalent of driving whilst looking in the rear view mirror (or at best, out of the side window of the car).  You need to look out of the windscreen in order to have the best chance of driving safely.  The trouble with doing that in terms of the stock market is that the visibility is often so poor, it feels like driving in fog.]



Markets are second order systems

Such approaches to investment are almost all futile.  Markets are second order systems.  What this means is that in order to successfully implement such market timing strategies:

1.  you not only have to be able to predict events - 

• interest rates, 
• wars, 
• oil price shocks, 
• the impact of the coronavirus, 
• the outcome of elections and referendums - 

2.  you also need to know what the market was expecting,

• how it will react and 
• get your timing right.  

Tricky.



Reference: Financial Times

Arguing against market timing

1.  While waiting for the market to fall, it is possible to miss out on growth in companies with good prospects (some ten-baggers made their biggest moves during bad markets).

2.  Following the fashionable trend may lead to serious mistakes in the choice of investment targets.


The market is overvalued when there are no suitable investments at suitable prices.

There is no reason to worry about an overvalued market.

The way you will know when the market is overvalued is when you cannot find a single company that is reasonably priced or that meets your other criteria for investment.  (Lynch and Rothchild, 2000)

Peter Lynch holds the same view as Buffett on market timing.

Lynch doesn't believe in predicting markets, but believes in buying great companies - "especially companies that are undervalued, and/or under-appreciated."

"Things inside humans make them terrible stock market timers.  The unwary investor continually passes in and out of three emotional states:  concern, complacency, and capitulation."

Both investors prefer falling markets.

A good 300 point drop creates some bargains that are the "holy grail of the true stock picker."

The loss of 10 to 30% of  net worth in a market sell-off is of little importance.

Peter Lynch views a correction not as a disaster, but as an opportunity to add to a portfolio at low prices:  

"This is how great fortunes are made over time."

"Time in the Market" versus "Timing the Market"

Timing is of no real value to the investor unless it coincides with pricing

The farther one gets from Wall Street, the more skepticism one will find, we believe, as to the pretensions of stock-market forecasting or timing. 

• The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking. 
• Yet in many cases he pays attention to them and even acts upon them. 

Why? Because he has been persuaded that

•  it is important for him to form some opinion of the future course of the stock market, and 
• because he feels that the brokerage or service forecast is at least more dependable than his own.*

A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stockmarket analysts. But it is absurd to think that the general public can ever make money out of market forecasts. 

• For who will buy when the general public, at a given signal, rushes to sell out at a profit? 
• If you, the reader, expect to get rich over the years by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market. 
• There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.

There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice.

• Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. 
• The idea of waiting a year before his stock moves up is repugnant to him. 

But a waiting period, as such, is of no consequence to the investor. 

• What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy? 
• He enjoys an advantage only if by  waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. 
• What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Warren Buffett's Long-term timing of the market and the Rational Investing Model

I recently posted:

New Investing Idea: The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model

and pleasantly received a reply from the author of the above article:

Rob Bennett said...

This is Rob Bennett, author of the Google Knol on "Why Buy-and-Hold Investing Can Never Work." Thanks for sharing some of the ideas set forth in the Knol with your readers, BullBear. If you or others have questions, I'm happy to help out to the extent that I am able. Rob

My comments:

Thanks Rob for allowing me to share your article in my blog.

Buy and hold strategy is safe for selected stocks.  Those using this strategy should be stock pickers; having only good quality companies in their portfolios and only buying them when their prices are obviously at bargain or fair prices.  Over the short term, the returns will be volatile, but over the long-term the returns on these investments will be predictably positive reflecting their fundamentals.

Though incorporating a long-term market timing based on valuation of the market may increase returns, like any market timing strategy, it may also impacts negatively on the returns too.

However, there are the very few periods when market timing can be usefully employed with a high degree of confidence and conviction.    Those with a good understanding of the valuation of the stock market can  employ this infrequently to their benefit when the valuations of the markets are obvious at the extremes.  Warren Buffett had done this on a few occasions in his very long investing lifetime.  In other periods (the majority of the time), buy and hold for the long term is safe and it works (my personal testimony), but for selected stocks only bought at bargain or fair prices. 

Investors would be impressed that Warren Buffett did make adjustments to his allocations to equities at certain periods during his long investing career.  These adjustments were based on valuations of the stocks and the market.  There were periods his exposure to equities were low when he felt the market was overpriced.  At one stage, he returned cash to all his investors as he could find no value in equities to justify continuing investing their money in stocks.  And there were the few occasions when Warren Buffett saw deep values in stocks and invested heavily, usually at the bottom of bear markets.  Yet, these were the times when other investors were most fearful.

What Warren Buffett did was essentially quite close to what Rob Bennett has written:

The Rational Investing Model encourages investors to take price (valuations) into consideration when setting their stock allocations.

Though we often hear only his "buy and hold forever" mantra, Warren Buffet has in fact been cleverly employing the equivalent of THE RATIONAL INVESTING MODEL, incorporating long-term market timing based on valuation of the market in his allocation of his money to stocks. 


The links below documented these actions by Warren Buffett:

*****Warren Buffett's commonsense approach to valuing the stock market

Buffett's success in gauging market conditions and profiting from them

Buffett: Keeping abreast of market conditions

*****Buffett's Shrinking Portfolio of the 1980s (1)

*****Buffett's shrinking portfolio of the 1980s (2)

Also read:

http://knol.google.com/k/why-buy-and-hold-investing-can-never-work#

http://www.getrichslowly.org/forum/viewtopic.php?f=2&t=4882
 
http://arichlife.passionsaving.com/2010/02/08/get-rich-slowly-forum-discusses-how-buy-and-hold-caused-the-economic-crisis/

http://www.retireearlyhomepage.com/bennett.html


and this:

A Better Approach to Investing from Rob Bennett of A Rich Life
I'd like to introduce you to a very solid approach to investing from Rob Bennett, author of A Rich Life. His investment approach has been given many names (the one I use for it is dynamic asset allocation). The principles are sound and over the long run, it will serve to reduce overall risk in your portfolio while providing more than adequate returns when compared to static or strategic asset allocation methods. To learn more, read on...
http://www.wealthuncomplicated.com/wealthuncomplicated/2009/05/a-better-approach-to-investing-from-rob-bennett.html

New Investing Idea: The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model

The core Buy-and-Hold claim is that changing one's stock allocation in response to big price changes is not necessary for long-term investing success.

The Rational Investing Model encourages investors to take price (valuations) into consideration when setting their stock allocations.


History of Buy-and-Hold approach

Buy-and-hold approach is when investors maintain the same stock allocation at all times, irrespective of the market valuation.

Most middle-class workers have long had a fear of investing in stocks because of the big losses associated with this asset class at times of stock crashes. The promise of a scientific, long-term approach held great appeal. Few middle-class workers studied Buy-and-Hold to the extent needed to understand where the ideas came from or why they were supposed to work. But most quickly grasped the essential point being promoted -- this was responsible investing. Buy-and-Hold became popular because it was viewed as being a rejection of the Get Rich Quick thinking that had given much investment commentary a bad name.


Why Buy-and-Hold can never work.

It's easy today to explain why Buy-and-Hold can never work. The root idea is preposterous (but not obviously so to those who have not yet seen through it -- there are many smart and good people who possess a strong confidence in the concept). For Buy-and-Hold to work, valuations would have to have zero effect on long-term returns. Stocks would have to be the only asset class on the face of Planet Earth of which it could be said that the price paid for the asset has no effect on the value proposition provided. This cannot be. Price must matter. And if price matters, investors should not be going with the same stock allocation at times when valuations are insanely high as they do when stocks are fairly priced or low priced. Buy-and-Hold defies common sense.


The science of investing

The science of investing showed that short-term forecasting does not work and that a long-term focus is needed. The science appeared at the time to suggest that a Buy-and-Hold strategy (sticking to the same stock allocation at all times) makes sense.

The science did not prove that Buy-and-Hold works. The Greatest Mistake in the History of Personal Finance took place when the academics jumped to the hasty conclusion that the fact that short-term timing does not work necessarily leads to a conclusion that Buy-and-Hold is the only rational strategy.

But Shiller's 1981 research (confirmed by a mountain of research done since then) shows that overvaluation is a meaningful concept. Shiller showed that stocks offer better long-term returns starting from times of fair or low prices than they do starting from times of insanely high prices. Even many Buy-and-Hold advocates acknowledge today that valuations matter. William Bernstein says that valuations affect long-term returns as a matter of "mathematical certainty."

The market must ultimately be efficient, as the academics responsible for the Buy-and-Hold concept claimed. Yet the academic research of the past three decades shows conclusively that the market is not immediately efficient. What, then, is the full reality?

The full reality appears to be that the market is gradually efficient, not immediately efficient. It is investor emotions that determine market prices in the short term. But it is economic realities that determine stock prices in the long term (after the completion of 10 years of market gyrations or so). If the stock price rises too much higher than the price justified by the economic realities, opportunities open up for competing businesses to obtain the same assets on the cheap (relative to the market price assigned to them) and thereby to create a new business with the same profit potential as the overvalued one and thereby to pull the value assigned to it by the stock market down to reasonable levels. The market does indeed insure that stocks are priced properly. But it does not do this in an instant. The process can drag out for 10 years or even a bit longer.


What really works:  successful long-term investing requires long-term market timing

The strategic implications are earth-shaking. It turns out that we have been telling millions of middle-class investors precisely the opposite of what really works in stock investing. Since the market sets the price improperly in the short term and properly in the long term, successful long-term investing requires market timing (not the discredited approach of short-term timing, but long-term timing, which the historical data shows has always worked). The key to long-term success is to disdain the idea of sticking with the same stock allocation but instead always to be certain to adjust one's stock allocation as required by changes in the valuations assigned to the broad market indexes (only one allocation change every 10 years is required on average but it is essential that long-term investors make this change -- Buy-and-Hold never works in the long run because it argues that this change is not necessary or even that it is a good idea not to make the allocation change).


Discarding the Buy-and-Hold Era and adopting the Rational Investing Era

There is one step required before the transition from the Buy-and-Hold Era to the Rational Investing Era (The Rational Investing Model is the alternative to the Buy-and-Hold Investing Model -- it is described in some depth in articles and podcasts available at the http://www.passionsaving.com/ site) can begin in earnest. We need to persuade the many experts who advocated Buy-and-Hold to acknowledge the mistake and to thereby launch a national debate on what really works in stock investing. As of today, an institutional interest in preserving the status quo and avoiding the need to acknowledge mistakes has worsened the economic crisis and threatened to bring on a Second Great Depression.

We need a national debate on what works in stock investing. Buy-and-Hold advocates should of course be part of that debate. Buy-and-Hold advocates are smart and good people and have developed many rich insights despite the mistake they made about the core Buy-and-Hold claim (that changing one's stock allocation in response to big price changes is not necessary for long-term investing success). But we need a debate in which Buy-and-Hold advocates drop the pose of perfect understanding that has kept us from exploring new insights for so many years now. We need to see an openness to new investing ideas if our economic and political systems are to survive today's crisis. We need to rebuild optimism for the future by partaking in a fresh start in our effort to discover how stock investing works, We need to put aside those of the old rules that no longer work and replace them with better-informed new rules that do.


The Implication of moving from the Buy-and-Hold Investing Model to the Rational Investing Model

Many have lost sight of the point of investing analysis -- to help middle-class people finance their retirements. All this needs to change if our way of life is to survive the inevitable collapse of the Buy-and-Hold Model.

Our hope lies in coming to see the move from the Buy-and-Hold Investing Model to the Rational Investing Model (the Rational Model says that investors must consider price when setting their stock allocations) not as an investing question or an economics question but as a political question. We have a long tradition in this country of free speech. Free speech is permitted in our discussions of baseball and novels and nutrition and fashions. It should be permitted in discussions of the flaws of the Buy-and-Hold Model as well.


Summary

Buy-and-Hold can never work. But many of the insights developed by the smart and good people who brought us the Buy-and-Hold Model can do wonderful things to help millions when incorporated into a model that does work -- the Rational Investing Model, a model that encourages investors to take valuations into consideration when setting their stock allocations.


http://knol.google.com/k/why-buy-and-hold-investing-can-never-work#

http://arichlife.passionsaving.com/

Market Timing Based On Long Term Views Does Work: Just know the valuation level you are starting from

Stock Market Strategy: Market Timing Based On Long Term Views

Short-term timing does not work because stock prices are determined by investor emotions in the short term.


If that’s the case, then short term timing and trading the market would not work because there is no way to outguess an entirely emotional process. All the intelligence in the world gives you no edge in trying to anticipate emotional choices.


This leads us to the explanation that long-term timing DOES work. The market MUST set prices properly in the long term. If prices can be wildly wrong in the short term but must be roughly right in the long term, it should be possible to know in advance which way prices are headed (in the long term only, not in the short term) just by knowing the valuation level you are starting from.

Researchers have checked the historical data. This explanation, unlike the EMT-based one, stands up to scrutiny. The same data that taught us that short-term timing never works also teaches us that long-term timing always works. Thus — it turns out that just about everything that the experts have told us about investing in the stock market over the past 30 years is wrong. Oh, my.

I believe that long-term timing works. If you change your stock allocation in response to big changes in prices, you can earn dramatically higher returns while taking on dramatically less risk. Do this throughout your investing lifetime and you can retire five years sooner than you previously thought possible.

The old model for understanding how stock investing works is in the process of collapsing. The new model for understanding how stock investing works is in the process of being built. As investors, we live in exciting times!

http://thesmarterwallet.com/2010/stock-market-strategy-market-timing-long-term/

http://knol.google.com/k/why-buy-and-hold-investing-can-never-work#

Time, and not timing, is the key to successful investment.

So who has the best chance of success?

Another approach is to disregard the risks of market timing and to ask how great the benefits would have been if an investor's timing had been right.

Let us take a hypothetical situation of 3 people who invested a fixed amount every year for 20 years.

• Person A is extremely lucky and annually invests at a market low, as determined by a particular Stock Market Share Index (JSE All Share Index). 
• Person B is unlucky and annually invests at a market high.
• Person C invests on a 'random' date every year, in this case 31st January.

The compound return earned by

• person A over the period is 14.0% a year,
• while in the case of person B it amounts to 11.3%. 
• person C achieved a return of 12.9% a year. 

(Dividend income was not taken into account in the research.)

It is

• not surprising that an investment at a market low achieved a better return than an investment at a market high, but
• the difference in return between the high and the low/'random' date is less than expected.

Although there are times when you should be more heavily invested,

• the risk of underperformance increases considerably if you are continually with-drawing from and returning to the market. 

Investors who buy and hold have the best chance of being successful.

Market timing sounds good in theory. It seldom works consistently in practice.

Market timing is an investment strategy that relies on:

• your being able to predict the future so that you can protect your capital by not getting caught in any market downswing. 
• You must also know when the market is going to turn around, so that you can effectively exploit any new upswings.

A market timer must always make two correct decisions:

• when to withdraw and
• when to re-enter the market.

A major issue regarding stock market or unit trust investment is the question of whether or not market timing works.  Buying low and selling high is easier said than done.

A fund that applies market timing - buys or sells depending on the direction in which the market is moving -

• can prevent you from losing money in bear markets, but
• can also result in your missing out on bull markets.

Research has shown that although market timing sounds good in theory, it seldom works consistently in practice.

Anybody who sells stocks because the market is up or down is a market timer for sure.

Anybody who sells stocks because the market is up or down is a market timer for sure.

A market timer tries to predict the short-term zigs and zags in stock prices, hoping to get out with a quick profit. 

Few people can make money at this, and nobody has come up with a foolproof method. 

In fact, if anybody had figured out how to consistently predict the market, his name (or her name) would already appear at the top of the list of riches peole in the world, ahead of Warren Buffett and Bill Gates.

Try to time the market and you invariably find yourself getting out of stocks at the moment they've hit bottom and are turning back up, and into stocks when they've gone up and are turning back down. 

People think this happens to them because they're unlucky.  In fact, it happens to them because they're attempting the impossible.  Nobody can outsmart the market.

People also think it's dangerous to be invested in stocks during crashes and corrections, but it's only dangerous if they sell.

They forget the other kind of danger - not being invested in stocks on those few magical days when prices take a flying leap. 

It is amazing how a few key days can make or break your entire investment plan. 

Here is a typical example:  During a prosperous five-year stretch in teh 1980s, stock prices gained 26.3% a year.  Disciplined investors who stuck to the plan doubled their money and then some.  But most of these gains occurred on 40 days out of the 1,276 days the stock markets were open for business during those 5 years.  If you were out of stocks on those 40 key days, attempting to avoid the next correction, your 26.3% annual gain was reduced to 4.3%.  A CD in a bank would have returned more than 4.3%, and at less risk.

So to get the most out of stocks, especially if you're young and time is on your side, your best bet is to invest money you can afford to set aside forever, then leave that money in stocks through thick and thin. 

• You'll suffer through the bad times, but if you don't sell any shares, you'll never take a real loss. 
• By being fully invested, you'll get the full benefit of those magical and unpredictable stretches when stocks make most of their gains.

Market timing: The relative position of a share's price to its own intrinsic value is of greater importance.

The market's movements are not perfectly reflected in the movement of the individual share. 

• Even during the sharpest decline, some of the shares hold their value very well. 
• During the bull run, some of the shares do not go anywhere. 
• At the same time, some shares magnify the movements of the market by two or three times, while others (mainly blue chips) only partially reflect the market movements. 
• Thus even if we get the market timing right, it is not possible to match exactly what is achieved by the market. 
• The relative position of a share's price to its own intrinsic value is of equal if not of greater importance. 

Market timing is more an art than a science. 

• There are some people who are highly gifted and are able to make good market timing decisions.  And yet precisely because market timing decisions only have to be made once every 5 years, it is critical that they are made in the correct way.  
• One wrong decision can either leave one out of the market for several years (i.e. after missing the start of a new bull run) or suffer heavy losses (i.e. missing the start of a new bear run).  
• There are few of us who can be like Warren Buffet who made two timing decisions in 15 years and both of them were nearly spot on. 
• We can never hope to be like Warren Buffett but we can use records of past market movements to help our investment decision making.

*****Warren Buffett's commonsense approach to valuing the stock market

Warren Buffett does not possess a magic formula for determining when the stock market is grossly overvalued or undervalued. By all accounts, his decisions to plunge into or escape from the market are based on several commonsense factors.

1. The relationship between stock yields and bond yields.
2. The rate of climb in the world.
3. Earnings multiples.
4. The state of the economy.
5. The big picture.

----

1. The relationship between stock yields and bond yields.

EY = 1/PE
Bond yields = Coupon rate

• Buffett covets stocks that offer earnings yields that can surpass bond yields over time. (EY of stock > Bond yields)
• When bond yields are rising and threaten to overtake stock yields, the market is generally overvalued. (Bond yields > EY of stock)
• When stocks fall to the point where their earnings yields are above bond yields, they are most attractive.  (EY of stock > Bond yields)

2. The rate of climb in the market.

History tells us that the stock market cannot outperform the economy for very long. That is, you shouldn't expect corporate sales, earnings, or share prices to rise at rates in excess of economic output.

• If stock prices are rising at, say, four times the rate the economy is expanding, the market is primed for a fall at some point.
• Conversely, if stock prices are falling while the economy is surging, an undervalued condition may be opening up.

3. Earnings multiples.

In 1982, the PE ratio for the S&P 500 index was just 7 (Americans were willing to pay just $7 for every $1 corporations earned on their behalf).

By mid-1999, Americans were willing to pay $34 for every $1 of earnings generated by these same companies.

What explained the disparity?

• Falling interest rates accounted for some of the increase in PE ratios. Declining rates make every $1 of earnings worth more to an investor.
• Improved profitability also accounted for some of the increase in PE. By the late 1990s, corporate returns on equity and assets had reached 70-year highs. It stood to reason that $1 of earnings carried more value because corporations could reinvest earnings at high rates.
• Yet the majority of the climb in stock prices can be attributed to emotion - the sheer willingness of investors to pay higher and higher prices without regard to value.

When PE ratios are expanding faster than what could be expected, given changes in interest rates and corporate profitability, investors must be on the alert for a correction.

4. The state of the economy.

When the economy is running full throttle and there seems to be little chance of it sustaining present growth rates, investors should ponder whether to decrease their exposure to the stock market and find alternatives.

Likewise, during tough economic times, stocks usually fall to bargain levels and offer high rate-of-return potential. Using Buffett's 15% rule, you can quickly gauge whether stocks are worthy of holding.

The general rule is to buy during a recession (when PE ratios are at their lowest) and to sell when the economy can't get any stronger (and PE ratios are their highest).


5. The big picture

Because Buffett endeavors to hold a stock for several years or more, he must take a more holistic view of companies, industries, and the entire market before buying.

Buffett won't buy or sell a stock in response to near-term changes in a company's profitability, nor will he pin his hopes on a sector "catching fire" on Wall Street to sell at a higher price.

Instead, he assesses longer-term fundamentals in the economy and the market and examines whether those fundamentals can support higher stock prices. If a stock doesn't offer the potential rate of return he seeks, he is likely to sell the security or avoid buying.

http://spreadsheets.google.com/pub?key=t7u4BYlpDKstozulNims5Hw&output=html

From the above spreadsheet, Buffett prefers to play an economic cycle to the fullest, whenever possible.

• During a recession, when nearly all US industries are experiencing a downturn, Buffett is apt to load up on numerous stocks, knowing that several consecutive years of improved profitability lie ahead.
• When the economy peaks and odds favour an eventual slowdown, selling is the prudent course.
• When stocks fall to the point where their earnings yields (1/PE) are above bond yields, they are most attractive. (EY of stock > Bond yield)

Buffett's success in gauging market conditions and profiting from them

Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.

His ability to sense great perils in the market or see great opportunity when others see peril sets him apart from even the legendary market timers such as George Soros or Michael Steinhardt. It is also a chief reason he rarely suffers a yearly loss in his portfolio. His ability to find bargain stocks is well documented. Less known is his success in gauging market conditions and profiting from them. When Buffett begins talking up or down the market, it pays to listen.

His form of market timing is similar to Wayne Gretzsky's approach to hockey - don't go where the puck is, go where it's going to be. The great investors of the twentieth century all seemed to have a penchant for discovering undervalued securities, but they also were forward looking.

When a recession was under way, they didn't brood. They looked for signs that a recovery was at hand. And when the economy was strong, they stayed mindful of the risk of a slowdown and planned accordingly. When playing the market, they looked for catalysts that could propel an industry ahead, even when Wall Street had turned negative on the sector. Conversely, they wouldn't wait for boom times to end but would sell ahead of others.

Click: http://spreadsheets.google.com/pub?key=t7u4BYlpDKstozulNims5Hw&output=html

Warren Buffett owes his success through the years as much to what he didn't buy as to what he did. Likewise, what he sold - and when he sold it - played just as prominent a role in his returns as did decisions to buy and hold Coca-Cola, GEICO, or Gillette. Whitney Tilson of Tilson Capital Partners in New York, a frequent columnist to The Motley Fool website, reminds us that Buffett made no fewer than four distinct market-timing calls in his career, each of which proved correct and highly profitable.

MARKET CALL 1: SELLING OUT BEFORE THE EARLY 1970s BEAR MARKET.
MARKET CALL 2: GOING LONG IN 1974
MARKET CALL 3: SEEING THE OPPORTUNITIES THAT WOULD OPEN UP IN THE 1980s
MARKET CALL 4: AVOIDING THE 1987 CRASH

Again and again, Warren Buffett will tell you that he is not concerned about day-to-day fluctuations in the stock market. It doesn't matter to him whether the Dow Industrials rises 300 points in a single day or falls by the same amount. He doesn't care whether the interest rates rose or fell for the day, or whether his portfolio declined $200 million in value (a frequent occurrence in 1999, by the way). "The market is there only as a reference point to see if anybody is offering to do anything foolish," he was quoted saying in 1988, "When we invest in stocks, we invest in buisinesses."

Buffett: Keeping abreast of market conditions

Market Call 1: Selling Out Before the Early 1970s bear market

Beginning in 1968: Buffett began to express sincere worries over stock prices. Writing near the peak of the go-go market of the 1960s, Buffett seemed to sense imminent danger to investors.
1969: Unable to find enough quality stocks at reasonable prices, he folded his investment partnership in 1969, acknowledging that his form of diligent, research-intensive stock-picking couldn't compete in a momentum-fed, short-term oriented market. "Spectacular amounts of money are being made by those participating in the chain-letter type stock-promotion vogue," he wrote his clients. "The game is being played by the gullible, the self-hypnotized, and the cynical."

"I believed the odds are good that, when the stock market and business history of this period is being written, this phenomenon regarded as of major importance, and perhaps characterized as a mania." Frustrated by the lack of sensible pricing and the inability of value-oriented managers to make headway amid a sea of momentum value fund managers, Buffett liquidated clients' accounts, put most of his personal wealth into Berkshire Hathaway stock, and stayed mostly out of the money-management business for almost 5 years. He stayed on the sidelines while Americans experienced the most brutal bear market since the crash of 1929 to 1933.
1973 - 1974: The market declined more than 60% during the crash of 1973 to 1974.

Market Call 2: Going Long in 1974

1968: Market peaked.
1973-1974: Five years after the market had peaked, most Americans had turned disillusioned by the stock market. The average portfolio had dropped 40% or more in value. Investors holding the great blue chips of the day - Xerox, Walt Disney, IBM, General Motors, and Sears Roebuck, for example - saw their portfolios decline more than 60% during the crash of 1973 - 1974.
To investors caught in the middle, it seemed like there was no end to the panic selling. Some individuals tried holding their stocks, waiting for a rebound that never took place. Exhausted, they gave in and sold after watching their portfolios lose 50% of their value. The rest took their cues from the market itself. Daily declines reinforced a selling mentality: Selling begat selling, and an orderly market turned into a vicious cylce of losses.
1974: At the bottom, in 1974, few investors could be coaxed to reenter the arena. But Buffett, refreshed from a 5-year hiatus and sitting on plenty of cash, dove headlong into the same stocks the market could no longer tolerate. Like a boy in a candy store, Buffett found more values than he could possibly digest. An investor who plunged into the market at the 1974 low made a 74% return within 2 years.


Comment:

Buffett has a good understanding of market conditions. He has the ability to value stocks and know when stocks and market are overpriced. His action in completely getting out of the market was interesting. His patience in staying on the sideline was remarkable too. How many could stay in the sideline without reentering at the slightest correction? How remarkable it was too that he chose the depth of the market in 1974 to reenter. Superb ability indeed!

*****Buffett's shrinking portfolio of the 1980s (2)

http://spreadsheets.google.com/pub?key=t7u4BYlpDKstozulNims5Hw&output=html

The above table shows, Buffett entered the 1980s energetic, ready to dive into a market he saw as woefully underappraised. As the market rose in value without pause, Buffett's conservatism got the better of him. By 1987, he was holding large stakes in just three stocks. When the decade began, Buffett had amassed large positions in 18 different companies.

Warren Buffett does not possess a magic formula for determining when the stock market is grossly overvalued or undervalued. By all accounts, his decisons to plunge into or escape from the marekt are based on several commonsense factors, namely:

1. The relationship between stock yields and bond yields.
2. The rate of climb in the market.
3. Earnings multiples.
4. The state of the economy.
5. The big picture (holistic view of companies, industries, and the entire market).

*****Buffett's Shrinking Portfolio of the 1980s (1)

http://spreadsheets.google.com/pub?key=t7u4BYlpDKstozulNims5Hw&output=html

Market Call by Buffett: Seeing the opportunities that would open up in the 1980s

By 1979, the Dow Jones Industrial Average traded no higher than it did in 1964 - 15 years without a single point gain!

Pessimism hit extreme levels. The public had gradually shifted their portfolios into bonds, real estate, and precious metals, and brokers found it difficult to peddle even stocks with 15 percent dividend yields.

Leading market strategists of the day, predicting more of the same financial morass, implored investors to buy bonds and avoid stocks. Buffett saw things differently. From his perspective, quality blue-chip stocks were being given away; some sold for less than their book values, despite the fact that econmic prospects for the United States still appeared bright.

Corporate returns on equity remained healthy, blue-chip earnings were advancing at double-digit rtes, and the speculative frenzy that had destroyed the integrity of the late-1960s markets had finally been removed from the equation.

"Stocks now sell at levels that should produce long-term returns superior to bonds," he told shareholders. "Yet pension managers, usually encouraged by corporate sponsors that must necessarily please, are pouring funds in record proportion into bonds. Meanwhile, orders for stocks are being placed with eyedropper." How right Buffett was.

As Tilson pointed out, the stock market has returned an annualised 17.2 percent since Buffett penned those words. Bonds returned 9.6%.


Market Call by Buffett: Avoiding the 1987 Crash

By the mid-1980s, Buffett's buy-and-hold philosophy had been carved in stone. He maintained large stakes in his three favorite companies - GEICO, Washington Post Co., and Capital Cities/ABC (which later merged with Walt Disney) - and pledged to hold these "inevitables", as he called them, forever. He didn't share the same convictions about the rest of the stock market.

At the Berkshire Hathaway annual meeting in 1986, Buffett lamented that he could not find suitable companies trading at low prices. Rather than dilute his portfolio with short-term stock investments, and given the fact that Buffett's stock holdings had already provided him tens of millions of dollars in gains, Buffett opted to take profits and shrink his portfolio.

"I still can't find any bargains in today's market," he told shareholders. "We don't currently own any equities to speak of." Just 5 months before the 1987 crash, he told shareholders of his inability to find any large-cap stocks offering a high rate-of-return potential: "There's nothing that we could see buying even if it went down 10 percent."

In retrospect, Buffett's comments about a 10 percent decline ultimately proved conservative. Five months after telling shareholders of his dilemma, the stock market lost 30 percent within a matter of days.

His decision to whittle away his portfolio slowly before the crash undoubtedly kept Berkshire's stock portfolio from imparting too big a negative influence on book value.