persoMarket Timing is a top down view of the stock market and its prospects. Market Timing is an approach that attempts to determine when to be in the market, when to be out of the market and when to short (bet on a price decline by borrowing stock and selling with the hope to buy it back at a cheaper price and repay at cheaper prices). Market timing includes the following four components.
- Trends of interest rates: The future behavior of interest rates, i.e., the tightening or easing bias of the Central Bank. Interest rates are critical to market values for three reasons. Stocks are basically the present value of future earnings. An investor invests his money in an expectation of certain rate of return. The higher the general level of risk-free rates, the greater the expected rate of return and the lower the present value of future returns. Additionally, higher rates of return available in fixed income instruments drain 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.
- Investor sentiments: This is also a contrarian’s indicator. The more bullish the investor sentiment, the more bearish it is for the market. Various proxies are used to determine investor sentiment, including investor surveys as well as ratios of put premiums to call premium, mutual fund cash, new issues of new stocks versus all stocks in the benchmark index, etc.
- The valuation of the market as a whole: Various ratios, including Price earnings, Price to cash flow, Price to sales, and Price to book value are viewed against historical averages and ranges and subsequent market behavior. Additionally, the relationship between risk-free interest rates is reviewed. The lower interest rates, the higher he P/E in most circumstances. Interest rates are critical because they determine the rate at which future cash flows are discounted. They determine the relative attractiveness of other fixed income investments and finally rates determine borrowing costs for companies.
- The technical state of the market: The market can be considered extended and vulnerable if it is trading above its moving averages, is overbought using de-trending oscillators (stochastic, MACD, Wilder RSI, etc.), the Central Bank is tightening liquidity 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.