How Can I Time The Stock Market?

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Producing alpha, or a return in excess of that of the benchmark or index, is achieved by outperforming the market. To outperform the market you are required to have an edge over other participants. This edge may allow you to intuit whether prices are likely to increase or decrease. In this sense, the skill-set required is on par with those of a fortune teller or any other clairvoyant who can see the future. Any claim to be able to “time the market” is invariably false and more often than not made in aim of separating you from your money; whether its selling a new trading methodology, or “hot stock tips”. In the case of market neutral strategies which are not dependent on guessing high or low correctly (CTA’s for example), an investor may be able to ignore the movements of the market entirely. For an average investor however, accepting that trying to time the market is futile, will save you a lot of time. That said, lots of thought goes into trying to figure out how to time the stock market. Rather than trying to guess what will happen, it might be advisable to consider what has happened before…

In the past 70 years there has been a consistent decline in the holding period of stocks. In the past capital markets served the purpose of matching buyers with sellers, providing liquidity and funding to businesses so that they could expand and develop; purchasing a stock meant purchasing a piece of a company and sharing in its profits and growth via capital appreciation and dividends. Fast forward to 2016 where the average holding period of US equity is commonly estimated to be around 5 days. Profiteering and attempting to “time the market” and make fast profits has resulted in people looking at a company share more like a lottery ticket than a piece of a business. In terms of how this information may benefit you and your ability to make profitable investments it is important remain mindful of the function of capital markets and their constituents- businesses.

How Time Spent In The Stock Market Has Changed….Over Time

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Stocks are unitised pieces of businesses. Business sell goods and services for money. Money is a unit of transaction in a capitalist economy. As such, businesses (along with their stock) will be affected and influenced by the economy at large. It is possible that some companies will exhibit price increases despite a falling economy. It is also possible that some companies will exhibit price decreases despite a rising economy. Generally speaking, however, there is an overwhelming correlation between the stock market, and the economy. Luckily, the economy is easier to interpret than the stock market and usually can be said to be in one of the following stages.

How To Use The Business Cycle To Understand The Stock Market

how to use the business cycle to time the stock market
These stages, together, are known as the business cycle or the economic cycle.

Historically the duration of the business cycle has averaged around 7 years. This is not a hard and fast rule. Further, different countries will simultaneously be at different stages of their cycle, all with their own idiosyncrasies and differences which makes it hard to make objective comparisons across different economies and markets. 

If we acknowledge that markets are more likely than not to move in the same fashion as the business cycle then it would be advantageous to know when one stage is finishing and the next beginning. Herein lay the difficulty. Despite there being no shortage of economic indicators to gauge a countries economy there are any number of macroeconomic catalysts that threaten to change or threaten the status quo. Our prudent investor would not so much base his decisions entirely based on a judgement as to what stage we are currently in, but would most certainly be aware of where we stand with relation to previous stages of the cycle. Potentially the most profitable time to invest is during a depression. This withstanding, there is no way to calculate when a depression is going to end and things often get worse before they get better. Could you withstand the sustained losses before entering the expansion phase? For the majority, the answer is no.

The Credit Cycle And Stock Market Timing

Having acknowledged that stocks are the blood vessels of businesses that participate in cyclical movements, it will help to add a final macroeconomic lens through which to assess the market with a view to making equity investments. This filter, again inextricably linked to asset prices, would be the credit cycle.
“Credit”, is essentially borrowed money. The credit cycle represents the ease with which people are able to borrow this money- to access credit. The cycle goes through periods in which money is easy to borrow, where lending requirements are low and there more more credit available. This money commonly finds its way into investments and leads to an increase in asset prices. Historically, all financial asset price bubbles have coincided with an increased availability of credit. A (sub)prime example of this being the global financial crisis in 2008, triggered by the mass defaults on mortgages where credit was extended (money was lent) to people who were not able to pay it back.

how to use the credit cycle to time the stock market

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If we are able to identify where a country is in the credit cycle we are able to forecast an increase in liquidity which inadvertently flows into assets, buoying markets and pushing up prices. The availability of credit will facilitated by banks, in line with the governance of (in most cases) the countries central bank or ministry of finance. The extension of credit to investors and home-buyers, if coupled with quantitative easing by a central bank under an expansionary fiscal policy (asset buying) has historically lead to increased asset prices. This information alone will be invaluable to an investor considering what to do with their capital, and asking what will happen to a nations economy in the near-term.

History Can Show Investors Where We Are Today

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In summary, there is no accurate way to predict future market movements. Capital markets have been proven to be systemically inefficient, owing to their participants being emotional beings with prevailing behavioral biases- even in spite of universally available information.

Economies are more empirical in this sense, due to numerical assessment, not sentiment, and are more open to objective appraisal as a result. Understanding the link between the business and credit cycles with capital markets may provide another barometer with which to assess the suitability of certain investment strategies and this is likely as close as an investor will ever get to knowing how to time the stock market. As with other investment methodologies, this alone is not enough of a base upon which to construct a portfolio. Acknowledging macroeconomic cycles will however give a valuable insight into liquidity, which has historically entered into capital markets.

Sources and Further Reading

- JASSA  The Finsia Journal of  A pplied Finance  ISSUE  2 2012: Stock Returns And Holding Periods

- The Behaviour Of Individual Investors, Sep 2011, B. Barber, T. Odean

-  Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Credit-Market Sentiment and the Business Cycle David Lopez-Salido, Jeremy C. Stein, and Egon Zakrajsek

- IMF Working Paper: Does Supply or Demand Drive the Credit  Cycle ? Evidence from Central, Eastern,   and South eastern Europe  Greetje Everaert, Natasha Che, Nan Geng, Bertrand Gruss,  Gregorio Impavido, Yinqiu Lu, Christian Saborowski, Jérô me  Vandenbussche, and Li Zeng

- Accounting for Japanese Business Cycles: A Quest for Labor Wedges Keisuke Otsu

- Investment over the Business Cycle: Insights from College Major Choice IZA DP No. 9167 July 2015