Predicting Market Tops vs Observing Conditions

Lately, I have been hearing a lot of market top/crash calls. These have been going on pretty much the entire rally off of the lows (recall the disastrous Hindenburg Omen). The most recent comes from respected fund manager John Hussman, who while having a bearish bend, has an actual methodology.

I am no stranger to making market calls, even if I think forecasts are pure folly. The Cult of the Bear series was an exercise in valuation and psychology, and I was surprised at the focus on the number (Dow 6800) while everything else was ignored. Even though that target was eventually proven right, the key to investment success is in the timing of your moves. (Note the cardinal rule of forecasting: Give a date or a level, but never both at once).

Which brings us back to the current environment. Broad indices are up over 100% since the March 2009 lows; economic indicators are mixed, with data improvements offset by a series of setbacks. These issues need to be contextualized against the massive liquidity wave from the Fed and other central banks.

What’s an investor to do?

My suggestion is to not guess as to where the market tops out, but rather, wait and watch the road signs. The market will give you lots of indicators that it is starting to stumble, than lose its balance, ultimately pratfalling. Even 1987 has a 14% drop in advance of the Black Monday 23% crash. In 2007-09, we received plenty of warnings before the market reached its 666 lows — down 57%.

Therein lay the rub. Recessions start not from lows, but from tops. NBER defines a recession “start at the peak of a business cycle and end at the trough.” Recall that in 2007, markets peaked less than two months before the recession began.

Hence, if you are an investor, you should not be thinking about when to jump out, and move to all cash/bonds position. Instead, you should be looking for a variety of signs that suggest it is time to lower your equity exposure as a function of rising risk relative to potential gains.

Indeed, the action most people engage is called market timing — jumping in and out based on expectations of an imminent crash or rally. Instead, I would suggest they would be better off eschewing market timing and instead focusing on risk management. This is a process by which the investor raises or lowers their equity exposure based on factors other than expected short term market returns. This means your goal is not catching tops and bottoms, but generating good returns on a risk adjusted basis.

At some point in the future, I hope to detail what these elements are. It is mostly mechanical, based on elements of trend, valuation, market internals, and economic factors. Until then, stop guessing what the markets will do, and start watching closely what they are actually doing.

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Previously:
The PermaBear to English Translation Guide (October 15th, 2010)