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Stock Market Timing Based On Economic Cycles


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Stock Market Timing In a Nutshell

Economic Cycle
Stock market traders and investors from all backgrounds have spent countless hours trying to figure out stock market timing strategies that work to bolster their returns.  Timing stock market turning points is excessively difficult because there are so many variables that affect stock prices.  However, looking back at past stock market performance, there are some stock market timing indicators based on economic cycles that work quite well in predicting future stock market price action.  If a trader or investor is involved in trying to time the stock market, they would be wise to learn how these market timing strategies can help them make better market timing calls.

It is important to make clear what stock market timing is and what it is not.  Stock market timing is not an attempt to pick an exact top or bottom in the stock market, since doing so is in the realm of impossibility, due to the wide range of variables that affect the stock market levels at any given time.  Rather, stock market timing is about taking into consideration economic and stock market indicators to assess when the stock market may be nearing a mid-range turning point.  In other words, nearing a point at which the market is ready to transition from a bull market to a bear market or vice versa.  In the long-term, the stock market always goes up, but holding stocks for the long-term (decades) is the realm of buy and hold investing, rather than market timing.

Stock Market Timing Using Economic Cycles

Stock Market Indicators
The performance of the stock market is remarkably predictable over the years, when United States Federal Reserve interest rate policy and the state of the economic cycle are taken into consideration.  For the purposes of trying to time the stock market using the economic cycle, consider these four Stages of Federal Reserve interest rate and monetary policy.

Stage 1 is when the economy is initially recovering from a recession.  The Federal Reserve typically keeps rates low and expands money supply.  Economic growth is relatively tepid during Stage 1 and inflation is typically on the low side.  The stock market typically makes its biggest gains during Stage 1, as money rushes back into the stock market in the wake of a recession, anticipating better economic times ahead.

Stage 2 is when the economy is experiencing a sustained recovery and the Federal Reserve gradually raises interest rates off of their recent lows.  This is done to counter rising inflation pressures, as the economy improves.  The stock market will continue to progress higher during Stage 2, but gains are less dramatic.  Market timers need to prepare for the transition to Stage 3, which is the stage in which a stock market top occurs.

Stage 3 (Sell Stage) is well into an economic recovery.  The Federal Reserve continues to raise interest rates towards the high end of the range and reduces money supply, in response to concerns about inflation spiking higher.  Commodity prices rise during Stage 3 and corporate profit margins narrow, due to commodity and labor inflation pressures.  Stage 3 is when the stock market makes a mid-term top and transitions from a bull market to a bear market, as the Federal Reserve’s increasingly tight interest rate and monetary policies cause the economy and the stock market to top out.  A recession begins towards the end of Stage 3.

Stage 4 (Buy Stage) is when the economy is in recession.  The economy is in recession and the stock market is in full correction mode, and will possibly enter bear market mode, if the sell-off exceeds 20 percent.  Stage 4 may last for many months or even longer than a year.  During Stage 4, the Federal Reserve will lower interest rates and loosen monetary policy.  The Federal government may also take measures to stimulate the economy.  Stage 4 is when the stock market makes a mid-term bottom and transitions from a bear market to a bull market.
Stock Market Timing
How do you use the Stages provided above to time the stock market?  First off, you need to keep track of the state of the economic cycle and what the Federal Reserve is doing in regards to interest rates and monetary policies.  Once you have identified the current Stage that the economy and Federal Reserve are in, you need to act accordingly.

The time to sell is during the middle to later part of Stage 3.  The Federal Reserve raises interest rates so high and tightens monetary policy so much during Stage 3 that the economy is forced into a recession.  You want to sell stocks before the stock market participants catch onto a looming recession, which is why picking an exact top can be exceedingly difficult.

The time to buy is during the middle of Stage 4.  The Federal Reserve lowers interest rates and loosens monetary policy during Stage 4.  The Federal government will also typically provide economic stimulus during Stage 4 to boost the economy, in the form of tax cuts or temporary spending.  The time to buy during Stage 4 is when the recession is at a low-point, when the economic indicators, such as the unemployment rate and new unemployment insurance applications, are no longer getting any worse.  The stock market typically forms a bottom at the same time as the economic indicators reach a bottom, many months before a recession is officially over.  This is at the mid-point of a recession.  If a recession lasts 12 months, you would want to buy back into the stock market during the sixth month of the recession, rather than wait for the economy to fully emerge from the recession.

Be patient and do not ignore the indicators – The biggest mistake market timers make is that they are not patient enough or do not pay proper attention to economic indicators to time the stock market properly.  The reality is that stock market timing events only occur every few years.  One has to patiently watch the indictors for years at a time and act when they indicate a medium-term market top or bottom is approaching.

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Does Stock Market Timing Work?


The Pros and Cons  Of Stock Market Timing

Stock Market TimingA question that often crosses stock market traders and investor’s minds is: does stock market timing work?  Financial advisers strongly advise their individual investor clients to avoid stock market timing and to leave those types of trading strategies to professional traders and investors.  In reality, a strong case can be made both for and against stock market timing.

The case for stock market timing is that the stock market often does work in a cyclical manner, and if a trader or investor can identify reoccurring movement within the market, they can vastly increase their profits by timing when to buy into and sell out of stocks.  The case against stock market timing is that the stock market is erratic, and those who are not holding stocks because they are trying to time the market could miss out on unexpected upside moves in stock market averages.  Additionally, even if a stock market trader or investor properly identifies reoccurring movement within the market, many fail to act on the buy and sell signals they are provided by the stock market, and therefore fail to properly implement stock market timing strategies.

How To Implement Stock Market Timing Strategies

Unless one has the time to follow stock market events, then there is really no point in even attempting stock market timing.  If a stock market trader or investor is committed to following stock market events and identifying stock market buy and sell signals, then they can consider stock market timing.  Stock market buy and sell signals can include a wide variety of stock market indicators, from the average price /earnings ratio (P/E ratio) to investor enthusiasm (which is used as a contrarian indicator).  The key is to study the stock market timing signals and back-test them (see how they performed in the past), and then to act on them once they flash a buy or sell signal.  It is a good idea to use a variety of stock market timing signals to ensure you are not being fooled by an erratic signal.

A simple stock market timing strategy that does not require a lot of analysis, but is also not always a winning strategy, is to sell a portion of a stock trading or investment portfolio during earnings season, as stocks often enjoy a near term top when good earnings news causes them to spike higher, and then buy back the stocks for less before the next earnings season.  It is not uncommon for stocks to settle back after earnings season, when they are driven by news events rather than by earnings announcements.

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Trading a Retirement Account Can Lead To Greater Returns


Trading A Retirement Account Means Trading Economic Cycles

Trading a Retirement AccountConservative investment advisers live by the mantra of “buy and hold” or “dollar cost averaging” stock market investing, and would never recommend that a client start trading a retirement account to try to achieve greater investment returns.  These conservative stock market investing strategies leave retirement savings in mutual funds or other investment stock-based vehicles for decades, waiting for them to eventually appreciate in value over time.  While this strategy makes a lot of sense during periods of strong economic growth and for investors who have no interest in trying to make extra money from stock market swings, buying and holding stocks has proven to be a losing strategy over the past decade of anemic economic growth.  For more information about buy and hold and dollar cost averaging stock market investing, see:  How to Play The Stock Market.

High profile corporate bankruptcies in companies once thought rock solid, such as Enron and AIG, have proven the folly of buying and holding individual stocks in a retirement account.  Unfortunately for investors looking to protect themselves by buying broader based stock index funds, exchange traded funds (ETFs), and mutual funds, these broadly based investment vehicles have on average performed very poorly over the past decade.  Some select mutual funds have done better than the stock market indexes over the past decade; however, given the risk associated with holding stocks, the average returns from broadly based stock funds have been very disappointing.  Stock market index returns over the past decade have averaged less than 1% per year when averaged out over the 2001 to 2011 decade.  The Standard and Poors 500 Index (S&P 500) has only moved from the 1,200 range to the 1,300 range from 2001 to 2011, which is only an 8% move higher.  During this time period, there was a great deal of volatility that twice sent the S&P 500 more than 33% lower to below the 800 level.  More recently in 2011, the S&P 500 has dropped approximately 20% from peak to trough.

While stock market declines are unnerving for buy and hold investors, those willing to considering trading a retirement account can take advantage of stock market volatility to potentially increase the value their retirement account.  Trading a retirement account requires an investor to be in tune with the economic cycle and to have a great deal of patience.

Typically, the stock market discounts economic events six to nine months in advance.  If a sustained period of economic growth is showing signs of coming to an end and a prolonged Bull Market appears to be making a top, it could be a good time to move some retirement money from stock based investments in to interest bearing cash investments that are not affected by the movement of the stock market.  Once a portion of an investor’s retirement money is in cash investments, an investor has to be patient and wait for the stock market to change trends to a Bear market and for the economic cycle to run its course into an recession or economic slowdown.  Historically, the stock market has dropped an average of 25% from peak to trough, as the economy changes from growth to recession.

The time to move retirement money out of interest bearing cash investments and back into stock based investments is approximately half way through a recession, as sentiment on Wall Street turns excessively bearish and the economy appears bleak.  At this point, the forward looking stock market will start looking towards an economic recovery and will start moving higher long before a recession ends.  Given the performance of the stock market during past recessions, a new Bull Market should begin well before the economy actually shows signs of growth.  The new Bull Market will then sustain itself with continued stock market gains, as the economy starts to grow again.  For more information about trading the stock market trend, see:  Trading The Stock Market Trend.

Trading a Retirement Account Means Selling High and Buying Low

While it would be foolish for investors to sell all of their retirement investments and start trading a retirement account, it is not a bad idea in this era of low economic growth and anemic stock market returns to dedicate a portion of a retirement account to long term trading strategies that take advantage of the changes in the economic cycle and the stock market trend.  Trading a retirement account boils down to a simple long term trading strategy, sell stock-based retirement investments while the stock market is peaking, and buy them back while the stock market is in a trough towards the middle of a recession or economic slowdown.

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