Monday Morning: The time may be ripe for market timing

Market timing has been written off by many investors, and most investment experts who lived through the late 1970s and early 1980s will tell you that it doesn’t work, or at least that it is very, very difficult.

“Buy and hold” became the mantra.

Investors had become convinced that market timing was almost impossible to pull off because of the strategy’s lack of success, except for a short period in the 1970s. Even quantitatively based tactical asset-allocation models struggled in the bull market that began in 1982.

But a commentary by James W. Paulsen, Minneapolis-based chief investment officer at Wells Capital Management of San Francisco, has made me wonder. Market timing worked in the ’70s because the market traded for several years within a narrow range, he says. He suggests we could be on the verge of another period when market timing might pay off.

Mr. Paulsen argues that the U.S. stock market could be relatively flat over the next few years, trading within a narrow range just as it did for much of the 1970s, but for different reasons. In the ’70s, the flat stock market was in “an inflationary trading range,” he says.

Despite a tripling of corporate profits, the stock market remained flat as price-earnings multiples collapsed under the impact of soaring inflation and interest rates. “Today the problem is a persistently underheated economy,” he says.

Excess capacity is everywhere. Companies have no pricing power, and corporate profits are likely to remain disappointing. Meanwhile, p/e multiples are high and unlikely to expand much in the future.

But Mr. Paulsen’s prediction of stocks trading within a narrow range doesn’t mean the stock market will never go up. During the 1970s, he notes, there were several outstanding return years – 1975, when the market rose 37.2%, 1976, when it climbed 23.8%, and 1979, when it gained 18.4%.

Nor does a flatter market mean the market cannot set another new high, he says. “However, long-term returns will likely prove far less than in the last two decades.”

Mr. Paulsen doesn’t think the traditional market-timing moves between stocks and cash make much sense at this time because cash is a great inflationary bear-market alternative investment. That was the environment of the mid-’70s. But it is not an alternative in bear markets, which are deflationary. Instead, he recommends tactical asset allocation between stocks and bonds.

“Normally, stock and bond returns are positively correlated,” Mr. Paulsen says. “However, since the Asian debacle in 1997, they have become delinked.”

In fact, he says, the potential for tactical asset allocation has seldom been higher. His research suggests that stock and bond returns typically become delinked when inflation is near zero. Since 1997, he says, not only has potential return from asset allocation between the two increased, but the frequency of potentially profitable shifts has increased also.

wrong timing

Mr. Paulsen doesn’t like private equity or venture capital going forward because they are likely to struggle if the broad market struggles. Real estate, oil and gas limited partnerships, and gold are “inflationary plays,” he says, and unlikely to help much in a deflationary environment.

He recommends long-short hedge funds. “Alpha can be generated by these approaches, whether the stock market rises or falls, and actually may offer the greatest potential when the stock market frequently does a lot of both.”

Mr. Paulsen also likes international investments because he believes the dollar is likely to weaken. He likes dividend-yield stocks because yield could become more valuable and appreciated if the market does trade within a range.

He likes large-cap stocks because historically they do better during periods of declining inflation, and he likes high-quality long-term bonds because the real (inflation-adjusted) yield is historically high.

Finally, he believes there may be opportunities to gain by rotating between different market sectors at appropriate times because the average dispersion in relative valuation between sectors has increased since 1998.

Maybe the key to successful market timing is using it only when specific market conditions exist – that is when the market is volatile but going nowhere. And that’s a time when “buy and hold” doesn’t work very well.

Mike Clowes is the editorial director of InvestmentNews.