How to Excel at Timing the Market

By John Persinos
September 14, 2010

Sometimes, it’s not what you buy -- it’s when you buy. Stock market timing is a powerful tool, especially when you remember a basic rule of investing: Most of the time, the majority of stocks go up or down together.

To be sure, not every stock on every day follows the same upward or downward path of the major indices. However, if the broader market averages stick to a sustained trend for several weeks or months, the vast majority of stocks will follow suit. Understanding the basics of how to recognize these patterns can help even the inexperienced investor become a shrewd market timer.

1) Buy when the stock market is showing the classic signs of bottoming out (and sell when the market is at a top).

The goal of market timing is to recognize the best opportunities to buy low and sell high. So it makes sense to buy into a position at its lowest point and sell at its highest. However, even experienced fund managers have trouble finding the market's "tops" and "bottoms" consistently. A good rule of thumb for identifying these extreme peaks and valleys is to look for extreme behavior.

Classic signs of a bottom include hyperbolic pessimism in the media; extremely high “bear” signals from professional stock analysts; heavy insider buying at corporations; and huge mutual fund cash reserves. On the other hand, if it feels like the market is in a buying frenzy, it's probably a good time to sell (or hold off on buying).

Investors who chose to get into gold toward the end of 2009 learned this lesson the hard way. At the time, everyone was foaming at the mouth over gold, and for a good reason: Gold prices had steadily climbed +40% since the beginning of the year.

Using Google's "Timeline" search, I was able to track this wave by searching how often the phrase "buy gold" occurred every month. In each of the eight months leading up to the gold frenzy, "buy gold" is only mentioned an average of 89 times. In September 2009, the number suddenly doubles to 178 times. In November we hit the peak -- "buy gold" is mentioned 212 times. Clearly the media is screaming "BUY! BUY! BUY!" But looking at the price chart, it's obvious the right move is to sell. By December, everyone that was going to get into gold had already done so. With no one left to buy (and drive up profits further), gold suffered a $125 correction.

2) Buy if the market has gone above the 50- or 200-day average.

The moving average is a great line to judge whether or not a stock is technically healthy. Extremely high averages are a warning that the market is too optimistic, and fresh buyers are rare (because everyone already owns it). When this happens, the market will likely reverse, and the stock will begin to fall. Conversely, a very low moving average is a signal that a bottom is near. When the stock price starts to rise and finally crosses its low moving average, it's a very bullish signal. Remember, the shorter the moving average, the sooner you'll see an actual change in the market.

3) Follow the “corporate insiders.”

The shrewdest group of investors is the “corporate insiders” -- the officers and directors of publicly traded companies. These people know much more about their organizations than any analyst or broker. And to ensure that they aren't using that knowledge to exploit non-public information, the SEC requires them to report their transactions (which you can find on Yahoo! Finance -- just click on "Insider Transactions" on the left bar).

Mandatory reporting helps level the playing field for individual investors. Knowing when insiders are buying and selling can be a great indicator of which direction a stock is heading. Think about it: Corporate insiders are the ultimate advisors. They have a very deep and comprehensive understanding of their company and industry. They are intimately involved with all aspects of their company. And just like you and me, it's in their best interest to buy low and sell high.

So does following insider trading really work? History has shown that stocks heavily purchased by insiders outperform the broader market averages by roughly 2-to-1 in a bull market and fall only half as far in a bear market. In addition, stocks characterized by heavy insider selling tend to rise only half as much as the market averages when the primary trend is bullish and fall twice as hard when the primary trend is bearish.

Here's a great example of how individual investors can use insider transactions to their advantage. On March 17-18, four key executives -- including the CEO -- of Citizens Republic Bancorp (Nasdaq: CRBC) reported large share purchases. Within a month, prices had rocketed +70%.

 

Remember, following insider transactions is not as easy as mimicking their every move. Many insiders frequently buy and sell shares for a number of reasons. [Find more tips on the profit secrets of insider trading.]

#-ad_banner_2-#4) Observe the put/call ratio for signs of frenzied “fast buck” behavior, and bet AGAINST the gamblers.

This tool is a handy contrarian indicator that helps you gauge overall market sentiment. It's easy to calculate: Just divide the number of traded put options by the number of traded call options.

Speculators buy puts when they anticipate a stock will go down; they buy calls when they anticipate a stock will go up. So the put/call ratio simply measures whether more investors are feeling bearish or bullish. If there are more bearish investors, the ratio will be larger. When the ratio is large enough, it can signal an unwarranted bearish outlook that will soon adjust.

The data used for the put/call calculation is available on the website of the Chicago Board Options Exchange (CBOE). A reading above 0.8 on the 10-day moving average of the CBOE put/call ratio suggests a big buying opportunity; when the ratio drops below 0.4, a big drop in the market is probably imminent.

This article provides only a sampling of the major, most popular market timing indicators. There are many other timing indicators, some of them quite complex. Regardless of which you follow, always remember this rule of thumb: No market timing system can compensate for poor stock selection. Only use market timing in conjunction with other fundamental metrics.

[If you're still having a hard time timing the market, don't get down on yourself. Even the great Warren Buffett makes market timing mistakes.]