How much market timing is enough?

I know that's not the way the discussion is commonly framed. Usually one side is yelling, "Death to market timing! Long live buy-and-hold!" And the other is screaming, "Buy-and-hold is for nitwits!" or something even less complimentary.

I find that these arguments generate far more heat than light -- especially because neither side fights fair.

The market-timing advocates always trot out evidence that shows that any investor who bought at some historic stock-market top would have spent the next decade underwater. For example, the market timers note that if you'd bought the

S&P 500

index at the top in December 1972, you would have had to wait until the summer of 1982 to get even.

And the buy-and-holders always pull out figures that show that any investor who'd been out of the market for just the 50 days with the biggest gains over the last 10 years would have wound up missing almost all of the stock market's appreciation.

It's not that those numbers are wrong -- I've done the calculations, and they're accurate. But they aren't very useful. These examples don't have very much to do with the stock market that investors experience better than 95% of the time. On most days, the market doesn't crash or rocket. Huge bear markets like 1973-74, and crashes like 1929, just don't happen very often. On most days, the market doesn't climb 250 points.

I've been thinking about this problem a lot lately. On huge down days for the

Nasdaq Composite Index

, I've thought how nice it would have been to be 100% in cash. On huge up days, I've rejoiced that I was still 100% invested. And in between, I've thought about whether there is some "just right" middle way that would make market timing a useful tool instead of an ideological debating point.

Timing Can Be a Roll of the Dice

Making a call on the direction of this market -- which is what most market timers try to do -- is pretty dicey. Certainty is in very short supply. A call to go all cash or to stay 100% invested would be nothing more than a bet at this point.

But I think there's another way to use market timing -- what I'm calling my "just right" strategy -- which doesn't turn me from an investor into a gambler. Used this way, market timing can actually help reduce risk at a moment when you can't estimate the direction of the market with any certainty.

My "just right" method is based on two principles, and it has only three steps. The first principle is that cash is a great hedge against downside volatility in an uncertain market -- but, because cash doesn't appreciate on the upside, using this hedge gives up a significant amount of potential gain. The second principle is that some stocks are more volatile than others -- and that, therefore, in going to cash it matters not only how much you sell, but also what individual stocks you sell.

My "three steps" are based on those principles. They begin with a big-picture judgment of the entire market. Second comes a look at your portfolio. Finally, there's a closer look at any individual stocks you may own with higher-than-average potential volatility.

Follow These Steps

Let's take these steps one at a time.

The big picture: Are we entering a period of higher-than-normal volatility and greater-than-usual risk?

There's no scientific way I know to warn investors that rising interest rates or a slowdown in the economy is about to cause a stock market crash or set a bear market in motion. But market history does tell investors that the likelihood of bad things happening to their net worth increases when certain other factors are present.

A

Federal Reserve

that is bent on tightening upsets the financial markets, for example, and in the past, such a tightening has often preceded a market correction. Falling corporate profit of the sort we get when an economy's growth is slowing increase the risk of some market event that will bring valuations down. Combine factors like that with stock prices that are well above past peaks and a runaway market for initial public offerings of companies with the merest whisper of a business plan, and you've got many of the elements that have preceded market corrections -- or worse -- in the past.

That's enough to make me nervous -- especially because it's a pretty good description of the stock market in 2000. But I think it's important to acknowledge that this combination of factors isn't enough to prove that all of our portfolios are destined for destruction. Many of those same conditions were in place in 1995 and 1996 -- and 1997, and 1998 and 1999. Conditions were even worse in a few of those years. (Remember the near meltdown of the global financial system during the Asian debt crisis of 1998?) So, while I'm worried, I don't think the state of the investing art -- or my own crystal ball -- gives me enough conviction to go to 100% or even 50% cash.

The medium-size picture: Are there stocks in my portfolio with higher-than-average potential volatility?

My portfolio could be at either greater or less risk of blowing up than the market as a whole. A portfolio stocked with nothing but biotechnology, electronic-retailing and business-to-business Internet stocks would have suffered much worse damage than the market as a whole, or than the Nasdaq Composite in particular. That's certainly unquestionable in retrospect -- but I think it was also clear before the fact.

And going forward right now, I think any investor can make an even more informed judgment on the volatility of the stocks in a portfolio by looking at their performance over the last month or two.

Looking at Jubak's Picks, for example, I can see that during this period of extreme volatility,

Cisco

(CSCO) - Get Report

moved in a range between 80 and 57 -- a 29% difference between extremes. The 10-day moving average, which gives a better picture of where the stock was on most days after it peaked on March 27, moved between 76 and 64, or a 16% difference. Stocks such as

Nokia

(NOK) - Get Report

, with a 21% difference between extremes and a 9% difference between average highs and lows;

MCI WorldCom

(WCOM)

, with a 9% difference between extremes and 13% difference between average highs and lows, and

Applied Materials

(AMAT) - Get Report

, with a 30% difference between extremes and 7% difference between average highs and lows, make up a substantial group in this portfolio that is less volatile than the Nasdaq Composite. (That index showed a 34% difference between extreme highs and lows and a 26% gap between average highs and lows.)

There is another group of stocks in Jubak's Picks with greater volatility than the Nasdaq.

PMC-Sierra

(PMCS)

, for example, shows a 51% difference between extremes and a 35% difference between average highs and lows. I'd also put

Mercury Interactive

(MERQ)

, 55% and 37%;

Network Appliance

(NTAP) - Get Report

, 58% and 47%;

Commerce One

(CMRC)

, 75% and 63%; and

Puma Technology

(PUMA)

, 77% and 70% in that group. Two recent drops from Jubak's Picks,

Vitesse Semiconductor

(VTSS)

, 52% and 35%, and

National Semiconductor

(NSM)

, 39% and 27%, also belong to this higher-than-Nasdaq volatility group.

The little picture: Are any of these individual stocks volatile enough, and is the market risky enough, to make selling that individual position and holding the proceeds as cash worthwhile?

There's not much point, in my "just right" market-timing strategy, to selling stocks with less-than-average volatility. The narrowness of the range between top and bottom means that I have to be much more skilled -- or lucky -- to hit the right buy and sell points than I do with a more volatile stock. Otherwise, I lose money on both the buy and the sell. And I don't get as much downside protection from going to cash in one of these stocks as I would from selling a much more volatile equity.

I'd argue that by selling a stock that's more volatile than average, an investor gets more bang for the buck in two ways. Selling an equal dollar position in Commerce One instead of Cisco provides a much better reduction in volatility. It's as if the cash raised -- even though it is the same dollar amount -- has extra value as a hedge against a market decline. Second, the wider spread between the top and the bottom of the range gives an investor a better chance at making a profit on a sell/buyback trade. My main purpose is to reduce the potential downside of my portfolio by moving some of it to cash. But I sure wouldn't mind selling into this rally at a high and buying back at a lower price if we get another dip.

All Cash is Safe, But . . .

How much of my portfolio should I move to cash? To be perfectly safe in this market, using traditional methods of market timing, I'd go to 100% cash by selling everything I own.

My "just right" method produces a very different strategy. By dividing my portfolio into two groups, I've already taken some of my stocks off the table. There simply isn't any point in trying to market-time Cisco, Nokia, MCI WorldCom or Applied Materials. Given their relative lack of volatility, the rewards from selling them aren't nearly great enough to make market timing an attractive proposition. The character of the individual stocks makes them ideal for a buy-and-hold strategy.

Once I've taken that group off the table, I'm down to a group of 12 stocks in the "greater-than-market-volatility" group -- the five I named above (PMC-Sierra, Mercury Interactive, Network Appliance, Commerce One and Puma Technology), plus

JDS Uniphase

(JDSU)

,

RF Micro Devices

(RFMD)

,

LSI Logic

(LSI) - Get Report

,

SDL

(SDLI)

and

Cable and Wireless

(CWP)

and the two I just sold (Vitesse Semiconductor and National Semiconductor). Only these 12 stocks show characteristics that convince me that a market-timing strategy applied to them on a case-by-case basis would pass a risk/reward test.

Using my "just right" method, I'd sell only this group of 12 stocks in order to achieve the best mix of maximum safety, minimal tax bill and maximum potential upside in case the market takes off instead of sinking. The others in my current portfolio of 25 don't show enough downside risk to make them good candidates for market timing. All I'd do by selling them, in my opinion, would be to generate a massive tax liability in exchange for very little gain in safety.

Under traditional methods of market timing, you might consider moving 50% of your portfolio to cash instead of 100%, assuming your top-down market read -- like mine -- wasn't quite so dire. (After all, I think the Fed is getting near the end of its string of interest-rate increases -- for a while, anyway. And the supply of initial public offerings and secondary offerings is showing signs of drying up.)

But selling 12 or 13 stocks out of a 25-stock portfolio still gives up too much potential reward -- and generates too much in taxes -- in exchange for any added safety it buys.

I think my "just right" method, however, can give an investor something close to the same safety as a traditional 50% move to cash while keeping taxes down and potential gains high. My method would suggest a sale of half of the stocks in the above-average volatility group.

In the case of Jubak's Picks, selling five or six stocks in this group will, I believe, give me about as much safety, preserve more of the upside potential in my portfolio and generate less of a tax bill than the larger, indiscriminate sale of half of the portfolio. With the risk that comes from entering the weak seasonal summer period for technology stocks, the possibility that the Fed will raise interest rates by 50 basis points on May 16 instead of the 25 basis points that I believe are already built into the market, and the grinding effect that all this volatility has on investor confidence, I think the "just right" method generates a reasonable trade-off between risk and reward for my portfolio.

I think this same kind of analysis will work on your portfolio. If you own nothing but Cisco-like buy-and-hold stocks, you'll wind up doing nothing. And I think that's the right thing for you to do under these circumstances. If you own a substantial number of very volatile stocks, you'll wind up selling some -- might be fewer, might be more, depending on your top-down view of the risk at this market. And I think that reducing the volatility of your portfolio for the summer is a good idea.

This system avoids the extremes of market timing and of buy-and-hold. And I think that's just right for this market.

Of course, so far I haven't discussed how to decide which stocks to sell out of the target group. That's the subject of my next column.

Jim Jubak is senior markets editor for MSN MoneyCentral. At the time of publication, he owned or controlled shares in the following equities mentioned in this column: Applied Materials, Cisco Systems, Commerce One, Global Crossing, JDS Uniphase, LSI Logic, Mercury Interactive, MCI WorldCom, Network Appliance, Nokia, PMC-Sierra, Puma Technology, RF Micro Devices, SDL and Vitesse Semiconductor. Holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He welcomes your feedback at

mctsc@microsoft.com

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