Authored by Peter Cook via RealInvestmentAdvice.com,
If a Hall Of Fame existed for financial beliefs, “market-timing is impossible” would rank right up there with “diversification is the only free lunch in finance.” These statements have been validated by a large volume of peer-reviewed academic studies, so it is widely believed that there is no need to question their legitimacy. Although the declining value of diversification was addressed in Diversification Can’t Cure Overvaluation Disease, this article concerns the issue of market-timing for investment portfolios.
First, almost all investors are likely to agree that market-timing, as defined over short-term intervals and based on observed historical patterns, is impossible. In reality, financial markets are enormously complex systems in which a multitude of investors buy and sell in different magnitudes for different reasons on different days. On top of that, investors may respond (or be forced to respond) differently to a specific stimulus over time. While some investors may be able to make excess profits based on known anomalies (e.g., seasonality, small capitalization, valuation, momentum) over long periods of time, even these anomalies are unreliable over shorter periods of time. If some investors can create excess short-term trading profits, they probably do so because of structural advantages (e.g., informational advantages of market-making, or detecting and front-running corporate buyback programs). If anyone can create short-term excess profits without those advantages, these precious few certainly don’t and won’t advertise how they achieve their success, which means the rest of us might as well continue to assume it is impossible.
In contrast, the study of longer-term business cycles is valuable for the simple reason that business cycles drive capital markets cycles. Business cycles run for periods of years, not days, weeks, or months. So business cycle analysis is different from the common definition of market-timing because it is concerned with a much longer time horizon. It is difficult for anyone other than politicians to deny the existence of a business cycle, which includes both an expansion and a recession phase because they are a fact of economic life. A recent Goldman Sachs research piece not only acknowledges the existence of cycles but divides them into four phases and produces recommended asset allocations for each phase, as shown below.
Goldman’s investment recommendation for 2018 is based on the belief that 2018 lies within Phase 3, in which the economy is operating above capacity and growing. More broadly, Goldman’s chart and table show that identifying the Phases is a crucial determinant of investment success. For example, if 2018 truly lies within Phase 4, cash and bonds would outperform commodities and equities. The Fed appears to agree with Goldman’s analysis of Phase 3, based on its simultaneous campaigns to lift the Fed Funds rate and to reduce the size of its bond holdings that were acquired during its QE experiment.
In another admission that business cycles exist, Bank of America/Merrill Lynch (BAML) produces...