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10/21/02  

The elements of market timing including investor sentiment, trends in interest rates and fed action, overall market valuation, technical underpinning, and flow of funds. Market Timing is a top down view of the market and its prospects.

Marketing Timing

First, is the state and apparent trend of interest rates and whether the Fed is in a tightening or easing bias. Futures behavior in the fed funds and t-bills futures markets can give some hint. These contracts are listed daily in the newspapers and are quoted as a discount from 100. If the t-bill rates are expected to rise to 6.5% in December, the December futures would sell around 93.5. If the current rate is, for instance, only 5.5%, this expected increase could cast a considerable pall over the market, suggesting an imminent rate increase. . 

Interest rates are critical to market values for three reasons. Stocks are basically the present value of future earnings. An investor is willing to invest if he gets his money back in time at an expected rate of return. The higher the general level of risk free rates (US government borrowing rates), the greater the expected rate of return and the lower the present value of those future returns. Additionally, higher rates of return available in fixed income instruments siphon off money from the stock market by reason of deteriorating supply and demand dynamics. Finally, many companies employ debt in their capital structure. Higher borrowing costs hurt earnings. 

Lower rates or the expectation of lower rates has the opposite effect.

Second, is the state of investor sentiment, which is a so-called contrarian indicator. Generally, the more bullish investor sentiment, the more bearish it is for the market. Various proxies are used to determine investor sentiment, including investor surveys (Investor's Intelligence, for instance), as well as ratios of put premiums to call premium, mutual fund cash, new issues of new stocks versus all New York Stock Exchange Stocks, etc.

Puts are options to sell a given security at a strike price within a specified time period. If the price of the underlying security drops, the put will rise in price. A put buyer is betting on the possibility of a price drop. A call is an option to buy a stock at a strike price within a specific time period. A call buyer will see his option price rise as the underlying security rises. 

Intrinsic value of an option is actual true value of an option. If you a December Microsoft option at a strike price of 90, and the stock is trading at $92, the intrinsic value is $2.00. However, the premium will probably be higher, let's say the call option costs $4.00. The premium is the amount by which the option price exceeds the intrinsic value. 

If put premiums exceed call premiums, an unusual occurrence, is suggests very bearish sentiment, which is contrarian and therefore bullish. Conversely, if call premiums are very wide vis a vis put premiums, it can be very bearish. 

Third, is the valuation of the market as a whole. Various ratios, including Price/ Earnings, Price/ Cash Flow, Price/ Sales, and Price/ Book Value are viewed against historical averages and ranges and subsequent market behavior. Additionally, the relationship between risk-free interest rates (US treasury bills and bonds) are reviewed. The lower the interest rates, the higher the P/E in most circumstances. Interest rates are critical because they determine the rate at which future cash flows are discounted (the higher the rate the lower the value), they determine the relative attractiveness of other fixed income investment (the higher the rates in fixed income, the more money that gets siphoned off), and finally rates determine borrowing costs for companies.

See the section on fundamental analysis for further descriptions of these ratios.

Fourth, and finally, is the technical state of the market . See the section on technical analysis for a more refined discussion of this area.

The market can be considered extended and vulnerable if it is trading well above its moving averages, is overbought using detrending oscillators (stochastics, MACD, Wilder RSI, etc.), the Fed is tightening and interest rates are rising, valuations are high by most measurements, and sentiment is bullish. The market is considered oversold and attractive if the opposite conditions exist.

Some have reduced this market timing concept to a simple expression, "don't fight the fed and don't fight the tape".

Market timing is not an exact science. It is a guide to probability and risk of future price action in the markets. Top down investors basically buy and sell the market and determine relative cash and equity positions based on their market timing analysis.

While the four ingredients of market timing are most typical, other approaches to whether to be in or out of the market are used.  Flow of Funds (FOF) is an appealing approach to forecasting market direction. Specifically, this approach looks at the amount of money that becomes available to buy stocks. This is essentially a guide to the supply and demand dynamics. 

The sources of funds are new money flows into mutual fund investment managers (net of redemptions), other contributions to savings or pension plans,  plus stock buybacks, plus acquisitions of public companies for cash. The use of those investable funds includes Initial Public Offerings (IPO's), and secondary offerings (already public companies issuing more stock) with the balance (if positive) available to purchase and hence, bid up, the price of existing shares outstanding. If the funds flows are negative, cash must be freed up by selling stocks. If funds flows are positive, the market will rise even in the face of other apparent negatives.

The nineties have witnessed various events which have led to an extremely positive funds flow, which accounts, to some degree, for the unprecedented valuations equity markets in the U.S. have achieved. The aging of the population and hence the need to save, together with tax benefited plans offering tax deferrals and deductions like IRA's, 401(k)'s, and Keough plans have increased money flows. Most of the other outlets for excess funds in times past, like collectibles, precious metals, and tax shelters have lost their allure in these non-inflationary times or they have been legislated out of existence. 

Critique of Marketing Timing- Marketing timing has not been a terribly effective tool in the 90's. The market has had long periods of being overbought, overvalued, with the fed biased to tighten, and extremely positive sentiment, but the stock market has risen in the face of these normally negative factors.

Flow of Funds, in effect, has served to provide the buying power to overcome the tide of previously unfavorable market attributes. It would appear that one must define the circumstances that will critically harm positive funds flow and incorporate that into a Market Timing Tool for it to be truly effective. Until Funds Flows turn negative, it would appear this market will not be broken, not withstanding being overbought, overvalued, over-hyped, and with interest rates on the rise.

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