Using Investors' Emotions to Time the Stock Market? Yes, You Can

NEW YORK (TheStreet) -- Trying to time the market is a fool's errand that will end up costing you time and, more importantly, money in the form of trading costs, taxation on capital gains and the prospect of being un- or under-invested on up days.

At least, that's what proponents of the "buy and hold" strategy and executives at indexing firms like Vanguard advocate. Their argument, which draws a lot of water, is that the highest-paid mutual fund managers cannot "beat their respective index," after fees and expenses, with any degree of regularity.

Ok, that's fine, but we in the advisory world have clients to whom we report. And clients have these pesky things called "emotions."

Not everyone is comfortable plowing the majority of their net worth into something like the S&P 500 Index Fund (VOO). Plus, an index fund mimicking the performance of the S&P is unlikely to meet a high net worth client's objectives.

What if a client's primary objective is to "feel safe," or to "not take too much risk," or to "never lose more than 10% in a given year"....? Every client has different needs, and therefore every client should really have a different benchmark against which one can evaluate his portfolio. It's ignorant to think no measure of market timing is necessary to successfully manage money.

Can we time the market using investors' emotions as indicators? This is called behavioral finance, and I find it fascinating. But first we need to recognize that there is, in fact, an emotional cycle around which investors operate.

Where are we today in terms of the market's emotional cycle? Consulting the graphic below, I feel like we rounded the base of "optimism" sometime last year, with 2013 culminating in a stage of "excitement." If I'm right, then we are mid-"thrill" which, in itself, is pretty thrilling.

Courtesy of Northwestern Mutual

Next Stop: Euphoria

This isn't about calling a market top -- there is no formula to tell us how long each of these phases may persist. This is more about acknowledging the psychology associated with each, and becoming aware of the real risks to which our portfolios are subject. It's also about being willing to stick our necks out, and potentially look foolish for a period of time.

Could U.S. markets go higher from here? Sure. But how much gas is really left in the tank?

You may be watching headlines -- seemingly each day the past two weeks -- broadcasting all-time highs for the Dow and S&P 500. It's possible your portfolio is at its all-time high. Shares of many household names are at their all-time highs: Berkshire Hathaway (BRK.A), Boeing (BA), Clorox (CLX), Johnson & Johnson (JNJ), Macy's (M) and Wells Fargo (WFC) are all at their all-time highs. There may not be much further for such names to run.

But the "excitement" and "thrill" phases have not treated all stocks equally. Some still look cheap, in fact. Whereas those names listed above sit at or near all-time highs, comparable names are nowhere near theirs.

Compare Berkshire and Boeing to General Electric (GE), JNJ to Pfizer (PFE), Macy's to Target (TGT), Wells Fargo to Bank of America (BAC). General Electric, Pfizer, Target and Bank of America have severely lagged their peers. This fact on its own does not make them good values, but I doubt their annual shareholder meetings feel particularly euphoric.

"We bring good things to life (except our stock price)"

GE is a stock that -- due to the virtual insolvency of its GE Capital division during the crisis -- has traded like a bank for the past five years. A bank on the brink. Not taking into account its dividend, shares of GE are down 30% since 2007. Go back a little further and you'll see GE shares are down 15% over the past 10 years, and 20% over the past 15 years. The stock has been out-performed by your checking account since Jack Welch left in 2001.

You can run but you can't hide....

We aren't going to be able to avoid the Euphoria stage -- it's inevitable. But is it prudent to take no action in advance?

We have trimmed if not eliminated exposure to many positions in client portfolios this year -- just about every position that is at its all-time high. In some cases our portfolios look dramatically different today than they did six months ago. For example, our allocation to long-dated Treasury Bonds (TLT) is now at its highest point in years (after having been zero in January).

We can't avoid market cycles, but it's our job to prepare for them.

At the time of publication the author was long BAC,TLT and VOO.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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