Jonathan Davis: "Secrets of Success: No one sees when bullish turn to bearish" published by the Independent UK

Secrets of Success: No one sees when bullish turn to bearish
By Jonathan Davis
12 March 2005
The Independent UK

Market timing, a hundred academic studies have told us, does not really work. Calling the precise points at which markets turn from bullish to bearish, or vice versa, is simply not a feasible option. You might get lucky once or even twice in a row, but to hope to do it on a consistent, regular basis is the stuff of dreams (though that does not stop investment banks and a host of other dream-peddlers continuing to offer advice of this sort).

This is one reason why, for most of us, professional and amateur alike, a more sensible approach is not to try. It is a better use of your time and emotional energy to stick to focusing on a few big-picture trends and stick with them until or unless they begin to show signs of excess. Investing on a regular basis and rebalancing your portfolio once a year to adjust for valuation shifts is another tried and tested way of protecting your assets from bad timing calls.

Yet the reality is that most of us cannot resist getting involved in trying to call the twists and turns of each successive market phase. Market timing is an addictive drug, which fulfils some deep-seated emotional need we all share. Why do bull markets have to "climb a wall of worry", as the old market saying has it? Because deep down we are all market junkies and would not have it otherwise.

The same goes for the age-old debate about whether "growth" or "value" is the better investment approach. There is no debate, as far as I am aware: all the evidence I have seen shows that, in the long run, a buy-and-hold value-based approach will provide the better, more reliable returns. But it can be dull work putting such a philosophy into action.

The real fun in the stock market comes in phases when either growth stocks do spectacularly well as a class, or there is some great speculative surge that holds out the prospect of sudden, large-scale returns. We are seeing one develop in the mining and natural resources sector at the moment. You only have to look at the exotica now finding its way daily to the Alternative Investment Market (AIM) to see that. It is all intoxicating stuff - and probably worth joining in with your fun money. The evidence that we are entering a new long bull market phase in commodities and natural resources seems pretty robust. Coupled with a low interest rate environment (the essential precondition of any speculative bubble), that provides a useful backcloth against which speculative stocks can flourish.

Many new mining exploration companies now appearing will turn out to be worthless.

It will all end in tears, though not for some time. The prudent investor will look to play the new bull market in commodities in a more cautious, strategic way: for example, through well-diversified dedicated funds and the larger diversified oil and mineral companies.

There is, as the market strategist David Fuller points out, a common theme in these developments. It is what he calls "supply inelasticity", the notion that demand for many natural resources and industrial commodities is growing strongly while, after years of weak or falling prices, the investment needed to bring on new sources of supply will take time to mature. That imbalance will underpin the upward trend in the oil, gold and industrial commodities markets for some years to come, although the trend will be obscured from month to month by periodic sharp falls in prices.

By contrast, Fuller suspects that stock markets in general will shortly be heading in the opposite direction: in his view, we are now two years into a typical "bear market rally" that will in due course see Wall Street and other leading markets resume the secular downward trend that began in 2000. This seems a plausible argument to me, and one I find that is quite widely shared by the professionals whose opinions I rate highly. We should all be preparing ourselves for such an eventuality. As a long-standing Warren Buffett watcher, I think that this is also the real message contained in his latest letter to shareholders, which came out last weekend. Having moved a lot of money into bonds four years ago, and bought into the energy sector in a big way more recently, Buffett is now sitting on $40 billion of cash and signaling that he is not tempted by values in the stock market at current levels. But the most important thing to remember, as a pragmatic investor, is not to let feelings about markets, however strong they might be, tempt you into too much precipitate action - which is the real snare of market timing.

The bullish phase of the stock market is still running, and there is no powerful reason yet to jump off, at least without more compelling evidence that the markets have turned. Fuller advises us to look out for what happens to the Australian and New Zealand stock markets. In his experience, the markets that lead the global stock markets up tend to be the ones that "top out" first. Australia and New Zealand have both carried out that role in the global stock market rally of the past two years. When they start to deteriorate, that could be a powerful signal that the bigger market trend is drawing to an end - especially if it is seen to be combined with evidence that bond yields are also starting to rise. Just don't expect to catch the turn precisely. Most successful investors are brilliant market timers in retrospect, but rarely in advance.

What they tend to do, if they think the market might be turning, is put a small bet on the fact and then gradually increase their exposure to that point of view, if the subsequent market action suggests that the move is indeed becoming an enduring trend, rather than a short-term alarum of the kind that keeps all market junkies happy.