On market timing… Part 6: Conclusion Simple Linear Dynamics

Looking at the simple linear physical dynamics of the market timing problem and its relationship between money supply and money supply growth, we can see the following:

1. If the overall money supply remains unaffected and investor preferences, with respect to equity markets, return to their original level (say the 10% cash and 60% equities noted in section 2.1), then, the risk of the downturn falls squarely on those who have moved out of the market place. Those who hold diversified portfolios should be ultimately unaffected.

o The duel is between those who have moved out of equities and into cash. Ultimately, if cash preferences and cash balances move back to equilibrium, the transition is a zero sum game for the average market timer (before costs), with additional timing risks for the average and below. Obviously, those who are able to execute superior timing will earn a superior return, but the average market timing investor will ultimately lose out once we include transaction costs.

o There may well be an arbitrage return, but the timing and magnitude of this return (interest rate based return versus equity based return) is uncertain. However, this (arbitrage) is a valuation driven return and not a technical “avoid-the-market-drop”, wait-for-the-price-and-volume confirmation kind of return. An arbitrage based return is a short term fine tuning, “efficient-market-type-of-return”, but only a very small number of market participants can access this type of return.

2. In a real economy, the risks to those “out of the market” are not limited to “out timing” the other timers. There will be a) those investors, who will be buying low and reducing their own demand for money and, b) future money supply growth and future saving out of increased money supply growth and, c) in a global market place, reallocation of global demand which though unable to increase domestic money supply would reduce the demand for money within the market portfolio.

o In this context, during most time periods, the duel between those who have moved out of the market becomes complicated by new sources of demand that increase the odds against the success of market timing.

o Indeed, given the impact of money supply growth and value investors, market timers are more likely to depend on significant and persistent market declines that cannot be overcome by short term money supply growth and marginal reallocation of value investor cash holdings.

3. That mitigating the risks that market timers look to manage by selling risky assets when valuations are high and moving up, than when they are falling and down, makes more strategic sense. Indeed, if investors were to actively manage liability/consumption risks, then we might see fewer extremes in asset prices and an earlier transmission of excess asset focussed money supply growth into consumer price inflation.

The simple dynamics of market timing argues that there is little or no practical, economic rationale for market timing per se. While successful market timers may end up with higher risk adjusted returns (ex post), the end result, the absolute total eventual return, risks being marginally insignificant. Analysis of historical data that supports market timing a) ignores the global physics of the problem (it is impossible for large numbers of market timers to move out of the market place) and b) ignores the ex ante risk of the exercise itself – the true risk is not the average return to market timing strategies but the dispersion of that return. Indeed, hold a well structured portfolio capable of meeting financial needs, without having to sell equities, during the time frame associated with market timing and we have all the risk management a market timing exercise would provide.

If markets were only impacted by short term movements in risk preferences and preferred holdings of cash within portfolios (due either to small shocks or management of normal business cycle excess), then the issue of market timing would be inconsequential: there would be no risk in holding a long term asset allocation; markets and cash holdings would return to equilibrium and economies would keep on expanding. Normal market and economic risk should not impact long term financial security and most investors should hold to their long term asset allocation[1] profile, presuming it relates to their consumption/liability profile.

[1] Long term asset allocation should also bear in mind long term consumption/saving balances in domestic and global economies.

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