By Patrick McKeough, TSI Network.ca
Special to the Financial Independence Hub
Some investors believe that market timing—trying to figure out if the market will rise or fall—is or can be an aid to their investing decisions.
However, most investors who try to time the market find that it costs them money in the long run. When it works, it may help them make some modest profits or avoid some modest losses. When it fails, on the other hand, it often does so in a bigger way. At times it leads to ghastly losses.
The key risk in market timing is the “false signal.” That’s when the market does exactly the opposite of what the timer expected. In fact, some false signals may seem like sure things until they fail.
Danger of false signals
Market timers may multiply the danger from false signals by making much bigger transactions than usual. They can also raise their risk by shifting to more aggressive and highly leveraged forms of trading — delving into stock options or futures trading, for instance.
Right now, some investors are venturing into market timing without realizing it. They are trying to base investment decisions on the next movement in interest rates.
Many investors now take it for granted that the U.S. Federal Reserve and other central banks will soon reverse their long-time low-interest-rate policy and take steps to move interest rates up. That’s a logical assumption. After all, central banks have pushed interest rates down and held them down for an extraordinary length of time. But eminently logical assumptions have a long history of generating false market-timing signals.
Rates will rise, but no one knows when or by how much
Eventually, interest rates will go back up, with or without a push from the central banks. But no one can predict when that rise will start. No one knows if it will be slow or quick, how long it will last, or whether the rise will be volatile or steady.
A wide range of outcomes is possible. That’s because interest rates are just one aspect of the economic/business/political situation, but stocks and markets generally can react to virtually anything. That’s the key drawback of market timing. It tries to simplify market moves, by focussing on a narrow slice of information. The problem is that the market may be looking elsewhere.
A small or creeping rise in interest rates might inspire some investor to buy stocks. They may take it as a sign that the economy is gaining momentum. They may think rates are going up because businesses are competing against each other to borrow funds for expansion.
Eventually, a rise in rates will spur a market downturn. However, rates can move up for years before they hurt the market. Conditions are ripe for that to happen now. Interest rates are exceptionally low by historical standards. They are also extremely low in relation to dividend yields on stocks. They have to rise a long way before many investors will want to sell stocks and buy bonds. That sell-stocks/buy-bonds switch is what usually turns rising interest rates into a danger for stocks.
Of course, something else could come along and spark a stock market downturn. But right now, a modest rise in interest rates is, as investors say, “priced into” the market. That is, investors generally assume interest rates are headed up soon, and they have braced for it. It would take something more to spur a deep or lasting slump in the market.
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books.