Macro and Market Timers

I am sure that you have sensed a bias that I bring to the table about market and macro timers but I think I should make it explicit. I believe that there are ways in which you can beat the market in the long term, but very few of those ways involve market timing or calls about the macro economy. I know that there are stories in every market about great market timers, i.e., investors who made exactly the right call at exactly the right time about a market: Japan in 1989, dot-com stocks in 2000, housing in 2007 and financial assets in late 2008. Here is why I remain a skeptic:

a. Small sample: Unlike stock pickers who have to put out recommendations on hundreds of firms, the nature of market timing and macro calls (about exchange rates or the economy) is such that even the most long-standing forecasters have made only about 15-20 calls in their entire lifetime. As a result, rejecting the null hypothesis that successful calls are due to luck becomes much more difficult. For instance, a stock picker who gets 60 out of 100 calls right, is statistically beating randomness but we cannot reject the hypotheis that a market timer who is right 10 times out of 15 is just lucky.

b. Fuzzy recommendations: One aspect of market timing and macro forecasting that is frustrating and makes testing difficult is the fact that market timers often do not make specific recommendations. Again, the contrast with a stock picker is stark: when a stock picker tells you a stock is cheap, you can buy the stock and test out the recommendation. Market timers and macro forecasters often make recommendations that are not just difficult to convert into action but also impossible to put to the test.

c. Timing is everything: Anyone who makes a market call and sticks with it for a long period will eventually be right. However, the call itself becomes a bad one for investors who followed it, since they often would have lost far more money in the period where the call was wrong than they made back at the time the call turns out to be right. Thus, calling the dot-com bubble in 1997, the housing crisis in 2004 and the Japanese stock market bubble in 1986 should all be classified as mistakes rather than the right calls.

Historically, there have been far more investors who have been successful, over long periods, picking stocks than timing markets, but the allure of market timing remains strong. Here are three tests that I would suggest you put any market timer or strategy to:

1. Has the market timer been right often enough to reject the hypothesis that his or her success is entirely random?
t statistic for success = Proportion of calls that are right/ (0.5/ Square root of the number of calls)
Thus, a market timer who has been right 15 times out of 25, will have the following t statistic:
t = (15/25)/ (.5/5) = 1.00
Statistically, this does not beat randomness?

2. Is the market timer right at the right time or is he or she a Cassandra?
Market timers who are consistently bullish or bearish are dangerous. There is more of a personal psychological component to their recommendation than an analytical component.

3. Does the market timer provide fuzzy stories or make specific recommendations?
I have more respect for market timers who are categorical about what investors should do - buy or sell short a specific market - than those who tell meandering stories (that may actually read well) but leave investors confused at the end.

Finally, ask the question that needs to be asked of any successful investor or strategy? Why does the investor or strategy succeed? Every successful strategy needs an edge. Since that edge cannot be better information with market timing (whereas it can for individual companies), what is it?