Why and How to Time the Market

Why and How to Time the Market

Market Timing Can be Done!

Follow the Trend

Since I first got interested in the stock market, I’ve been attracted to market timing. Maybe it’s my inherent risk-averse nature. Maybe it’s my contrary nature (my interest started back during the post-1995 boom and bubble, when no one cared about market timing). Or maybe it’s my interest in history, and the knowledge that big bear markets do happen, and when they do, they can set investors back years.

Today, of course, market timing is much more popular than it was 20 years ago, mainly because of the two huge bear markets in the last decade, and the uncertainty surrounding the world economy even today. I regularly talk to subscribers who tell me the first thing they look at in Cabot Market Letter is page 6, which contains all our timing indicators.

But apart from Cabot Market Letter subscribers, few investors really focus on market timing—they’ve been told by the “experts” that it can’t be done. And if they try market timing, many stop following it after a short time. Instead, they use gut feel and other people’s opinions (like what they hear on CNBC, etc.)—and that almost always leads to sub-par results.

The second (and less well appreciated) reason is that most investors simply can’t bring themselves to follow a system, even if it’s proven. It’s hard to sell any stock; selling involves giving up hope the stock can head higher. But it’s especially hard, psychologically, to sell when the stock still looks good, yet market timing says risk has increased. And thus, many investors don’t sell even when the market turns down.

However, I’m here to tell you that market timing can be done successfully—and you can train yourself to follow its signals. I should know—I used to be one of those investors described above! Back in the 2000-2003 bear market, I ignored the market’s downtrend for months … and got buried because of it. In fact, The Cabot market timing system had decayed by 2000, as the Internet bubble “taught” us that we didn’t need to worry much about the market’s trend; back then, our indicators had lost their effectiveness and our trust in their value was fading.

After that, Cabot’s founder Carlton Lutts (who also appreciated the value of market timing) and I sat down and devised a new market timing system. It was a system that helped us stay an average of 50% in cash from the bull market peak in October 2007 to the bear market low in March 2009—and it had us 90% in cash during the 2008 crash following Lehman’s bankruptcy!

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So how did we do it? By refocusing our efforts on trend following, which in my opinion is the single best way to time the market. What I like best about trend following is that it directly measures the market itself—this isn’t about momentum indicators (MACD, RSI, etc.), breadth, sentiment or something similar, which are all secondary indicators.

The biggest advantage of trend following is that it’s the only market timing system I know of that is guaranteed to keep you in every major market unmove, and guaranteed to keep you out of every major market downmove. I don’t use the word guarantee often (if ever!) when it comes to the market, but this one is true.

Trend following makes up 75% to 80% of my market-timing stance, and I do it via two indicators. The first, dubbed our Cabot Trend Lines, is longer-term; it looks at both the S&P 500 and Nasdaq Composite in relation to their respective 35-week moving averages. If both indexes close above their moving averages for two straight weeks, it’s a buy signal; below for two straight weeks, it’s a sell signal. Simple.

The Trend Lines also provide a background-type message—they tell you whether it’s winter (and you should expect frigid winds and snow squalls) or summer (pack up stuff for the beach!).

For the outlook for the intermediate term (the next few weeks), we rely on the Cabot Tides, which look at five major indexes (the Nasdaq Composite, NYSE Composite, S&P 500, S&P 400 MidCap and S&P 600 SmallCap) compared to their 25-day and 50-day moving averages. If three of the five indexes close above their lower moving averages on their charts, and those moving averages are advancing, it’s a buy signal. Sounds complicated, but it’s not.

The Trend Lines (longer-term) and Tides (intermediate-term) allow us to have a detailed picture of which way the market is trending. (If you’re a shorter-term trader, you might add a shorter-term trend following indicator, but that doesn’t fit my style of investing.) When both indicators are negative, that’s enough for us to be in a defensive posture … but when both are bullish (like today!), it’s enough to be at least leaning bullish, if not heavily invested!

(Now, there’s more to my market timing system than just trend following—I also track the action of leading growth stocks, sentiment and the action of the broad market—but I’ll save those topics for another Cabot Wealth Advisory!)

One of the quickest and easiest ways to improve your investing results is to incorporate market timing into your methodology. And for my money, trend following is the best approach—it will drastically cut your losses during downturns and still allow for big upside during bull trends. Doing just that will put you ahead of 80% of investors.

So what’s going on in the current market? Things are looking a lot better than they did a couple of weeks ago—the Cabot Trend Lines and Cabot Tides are both positive, and growth stocks (my focus) are acting great, with many performing like champs.

That said, I still see a pretty meaningful divergence between the best growth stocks (which are doing great) and the broad market (which is so-so). Interest rate-sensitive securities remain under pressure, of course, but the broad market is also sluggish. For instance, when the Nasdaq hit a peak in mid-July, 401 stocks hit new highs. When the Nasdaq nearly touched 3,700 at the start of August, just 311 stocks hit new peaks. And this Tuesday, when the Nasdaq reached 3,730, just 207 stocks reached virgin turf.

Now, divergence isn’t a core feature of my market-timing system; it’s more descriptive than predictive. But what it is describing is a narrowing advance, which often leads to some potholes (sometimes large potholes) in the future.

TeslaThis isn’t to say I’m distrusting my market-timing indicators. Not at all! But when it comes to new buying, it’s imperative to be in the right stocks, and to be in them at the right price, so that you can survive any shakeouts that may come.

One area that hasn’t been in the public’s eye but seems to be emerging is the energy group. I know what you’re probably thinking—aren’t oil stocks just getting a lift because oil prices have been up during this Syria uncertainty? Maybe, but I saw many names in the group act well even when oil prices dipped this week.

One of the best acting stocks is Pioneer Natural Resources (PXD), which I wrote about in Cabot Top Ten Trader back on August 5:

“Pioneer Natural Resources is a good-sized energy explorer that’s operating in two of the more exciting plays in the U.S.—the Wolfcamp/Spraberry area, which is one of the largest oil fields in the entire world, and the emerging Eagle Ford Shale, which is liquids-rich and could end up being the most lucrative shale play in all of the U.S. Pioneer’s total production this year is expected to grow “only” 14% to 16%, but investors are focused on the company’s activity in these two areas and liking what they see. In the Wolfcamp/Spraberry play, production increased 7% sequentially in the second quarter as the company moves more of its drilling to horizontal from vertical; this production was strong especially as some output was “rejected” because of low prices. In the Eagle Ford Shale, output was up only a smidge in the second quarter, but should grow 35% to 50% for all of 2013 as Pioneer ramps up the number of wells it’s tapping. Also of note are advancements like pad drilling and cheaper propants, which are saving hundreds of thousands of dollars per well. Obviously, a collapse in oil or liquids prices would be bad, but analysts see earnings up 42% this year (to about $4.90 per share) and another 26% in 2014. It looks like an emerging blue-chip in the energy sector.”

Since that time, PXD pulled back for a couple of weeks with the market, dipping from 183 to 166, then rallied back to that old peak before a small retreat this week. I think the stock’s a good buy around here, with a stop near 165 in case things go awry. If the oil group is starting a new uptrend, PXD should be one of the leaders.

To get more updates on PXD as well as additional growth stock recommended in Cabot Top Ten Trader, click here.

All the best,

Michael Cintolo
Editor of Cabot Market Letter
and Cabot Top Ten Trader

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