Mebane Faber had a great post on Successful Market Timing. His post also contains excerpts from a Paul Merriman article called Do you have what it takes to be a successful market timer? Both are excellent reading.

As both Faber and Merriman point out, following a mechanical market timing system takes considerable discipline. While it sounds simple, emotions are a very powerful thing - they can compel us to act impulsively. To be a successful market timer, one must be able to control one’s emotions and impulsiveness. The beauty of a mechanical market timing system is that it is absolutely unemotional - the voice of reason. To the timing model it’s simply applying rules and formulas to a bunch of data. To humans it’s a tug between the extremes of fear and greed. 

Whenever you start to feel fear and doubt, go back and read Faber and Merriman to get grounded. Deep inside, you just might have what it takes.

As a child my mother used to tell me those timeless words when I would want what I wanted when I wanted it and couldn’t have it. “Buy-and-hold” stock market investors are probably tired of hearing those words about now. The S&P 500 Index has declined nearly 50% from its peak. With the global financial crisis continuing to unravel world economies, not many people are comfortable making bets about how long it will take to break even this time around

Everyone has heard about the US stock market crash of October 1929, but few people remember that it took 25 years for the market to recover to its former peak.

Japan’s stock market – the world’s second largest – peaked in 1989. It has been nearly 20 years and the level of the Japanese stock market is just 20% of its peak value.

Today I looked at the education accounts I set up for my grandchildren. I use a form of buy-and-hold called “dollar cost averaging” where so many dollars per month are automatically deposited into each child’s education (529) account. Unfortunately, I don’t have the choice of following the Sage Investment Strategies Timing Model. Instead, the deposits are invested in a “target date” fund that is automatically adjusted to invest more conservatively as the child’s 18^th birthday approaches. My grandkids’ accounts have lost more than 35% of their value and I wonder how long it will take those accounts to break even. Maybe they will never make any money, depending on how many years it takes the market to come back.

The only way I have ever consistently made money in the market is to unemotionally follow my own mechanical timing model. Before developing my model I tried others’ timing models and was not happy with the results I got. The owners didn’t explain the model’s historical drawdown or standard deviation – only how much money I could have made if I had only been smart enough to find them 20 years ago. After following their timing signals I took a bloodbath when the market turned. I found out the hard way that their positions were too concentrated – not well diversified – and that the portfolio value could fluctuate wildly. Once again I learned the old saying “Patience is a virtue.”

I’m not implying that my mechanical timing model is a get-rich-quick scheme – it’s not – although looking at the recent results of the SIS Long & Short Portfolio strategy one might get a different idea! What I like about the Sage Investment Strategies model portfolios is that I sleep soundly at night without worrying about my investments. I used to worry a lot about our financial future every time a market downturn came along and we lost money.

I never had confidence in buy-and-hold as a strategy. I never had confidence in the market timing strategies of others that I tried. And I quickly lost confidence in the professional money managers I hired because they didn’t seem to do any better than me! But I am so confident in the Sage Investment Strategies Timing Model – or SISTM as I call it – that I use it to manage 100% of my own, my wife’s and my 87-year old widowed mother’s investments.

As much as it takes discipline and patience to follow a buy-and-hold strategy without wavering, one must possess the same virtues to follow a mechanical timing model. Some subscribers may be tempted to second-guess the model, especially if the SISTM generates a signal contrary to what they are feeling or expecting. Or perhaps they are following one of the SIS (Sage Investment Strategies) portfolios but maybe its performance is lagging behind other SIS portfolios or the benchmarks.

While it takes virtues of both discipline and patience to stay the course with whatever strategy one follows, I take great comfort in following a system that won’t take 25 years to break even.

Financial pundits have long intoned a mantra that timing the market is a fool’s game that cannot be won. Conventional wisdom stipulates that one should buy and hold a diversified portfolio of investments across multiple asset classes and develop the self-discipline to stick to their buy-and-hold strategy through stock market ups and downs. Moreover, conventional wisdom holds that the stock market will always go up over the long term, so eventually disciplined investors will make money.

The fallacy of conventional wisdom is the use or implication of the word “eventually” in the same sentence containing the statement “stock markets always go up over the long term.” Consider the plight of “disciplined” investors who bought in at the peak of dot-com frenzy in March 2000. They have experienced 8 years of pain waiting for their ship to come in. The NASDAQ lost nearly 80% of its value and is currently less than halfway back to its March 2000 levels. Or consider the plight of “disciplined” investors who bought at the peak of the Japanese Stock Market in 1989 when the Nikkei Stock Index reached an intraday high of 38,957.44. Almost 20 years later the Nikkei stands at less than a third of its 1989 peak. These are but two examples from scores in global stock market history.

Who has the fortitude to follow conventional wisdom and put their financial future on hold for 5, 10, 20 or more years just to get back to break-even? Just because they were unfortunate to make a sizeable investment at the market’s peak, why should they be doomed to wait out the comeback? Critics of market timing are adamant that it is impossible to time the market successfully compared to a buy-and-hold strategy over the same period.

Is it true that markets are totally random? Of course not. Markets move in cycles and there are a variety of mathematical indicators that can be used to measure these cycles.  But the problem with many market timing models is that their developers come up with algorithms that are optimized to work great with one set of historic market data from a particular time period but do not work reliably when applied to other markets or “live” time periods. This type of mistake is often referred to as “curve fitting.”

While they are few and far between, successful timing models (1) work across many different markets and time periods; (2) exhibit investment returns that are greater than or equal to long term stock market returns and (2) generate lower volatility and less risk than a buy-and-hold strategy.

Who will history show to have played the fool’s game - disciplined subscribers to proven market timing systems or determined buy-and-hold investors who stay the course regardless of portfolio drawdown and however long it takes to break even after the ravages of a protracted bear market?