Over the years I have given a lot of thought to a market timing strategy. I first wrote about it here in July 2007 when I demonstrated that the stock market was overvalued and warranted a reduction in equity exposure. Since then I have also blogged about the results I have achieved with market timing, which have ever so slightly cushioned some of the blow from the recent market declines.

In subsequently thinking about this topic and discussing it with friends I have come to realize that what I refer to as market timing or hedging can just as easily be thought of as frequent portfolio rebalancing. I wanted to see how the results of rebalancing compared to what I’ve been doing for the last 8 years so I decided to test it. I ran analyses of two different portfolio rebalancing strategies under a scenario where the market declines steadily over the course of 14 periods, where a period is defined in terms of a 5% drop in market value from the previous level - much like my buy and sell thresholds. At the end of 14 periods the market is at approximately 50% of its original level - not too different from where we are today. Under each strategy I started with a portfolio that was 70% equity and 30% cash - $1MM total to make it easy - and rebalanced the portfolio at the end of each period.

The first strategy is based upon maintaining a constant 70% equity exposure and is demonstrated in the table below.

As you can see, over the course of time each subsequent stock purchase becomes smaller as the portfolio shrinks and smaller purchases are sufficient to offset the market declines. At the end of the 14 periods the total portfolio is down to a bit less than 61% of its former self and the cash position is down to $182K from $300K originally. Of course, I would argue that with the market at a lower level the portfolio is well positioned to benefit from any recovery, which is the basis of my market timing strategy.

The second strategy is much closer to the approach that I have been taking and is based upon maintaining constant dollar stock purchases - initially matching the stock purchases in the first strategy - and is demonstrated in this second table.

Surprisingly, at the end, the total portfolio value isn’t that much different than under the first strategy but cash is about $30K less. The main difference with this strategy is that at the end the portfolio is almost 75% equities, up from an initial 70%. This seems reasonable, and might even be too conservative. If one believes that 70% is an appropriate equity allocation at one level of the market wouldn’t a higher allocation be reasonable when the market is 50% cheaper?

I draw a couple of conclusions from this exercise. First, when faced with a rapidly changing market, I believe it makes sense to frequently rebalance the portfolio to take advantage of higher or lower valuations. Why should you wait until the end of the year when things might be a wash? Second, given the numbers from the second strategy, I think I have been too conservative in the magnitude of my incremental investments as prices have gone down. Of course, I’m waiting for the market to drop another 50% to really pick up the bargains.

Authors note: I thought it would be appropriate to keep this article short so if you want some detailed information on how shorting works check out this entry in our encyclopedia.

There comes a time when you may want to take a short position and when that time comes you need to be aware of some of the potential pitfalls and how to avoid them.

First, why would you want to do something like this? Let me give you a few sample scenarios, though there are many others:

1. You are convinced that a particular stock is overvalued and you want to profit when everyone else figures out what you’ve known all along. A side benefit of doing this is that if the company goes bankrupt you never have to close out the short position and thus you avoid paying income taxes.
2. You want to hedge your investments. You like your individual stock selections but you’re nervous about the direction of the market so you sell the market short. Shorting one of the many ETFs that represent various indices will eliminate that market risk from your portfolio.
3. Perhaps you’ve sold a put option on a stock but want to insure yourself against the possibility that the stock will decline. Of course, in this case you will lose if the stock moves up.
4. You find a closed end fund that is selling at a substantial premium and there are comparable closed end funds or ETFs that are selling at net asset value (NAV) or below. You can short the fund trading at a premium and buy the fund trading at NAV.

Aside from the inherent risk of unhedged shorting (like having unlimited downside), there are several other ways you can get stuck with the short end of the stick if you don’t know what you are doing. Let’s start with how shorting is executed and who gets what out of the deal. Your broker borrows a client’s stock and sells it. First and foremost that means that the stock has to be available for shorting. If the stock is not widely held there is a very good chance that your broker can’t find a position amongst all of their clients from which to borrow. Without a lender you cannot execute a short transaction. I’ve run into this dilemma many times. However, your broker has a stock lending department that can help in these situations. They can go outside of their firm and find the shares. For this service you pay a small fee. Fidelity charges 2.5% of the average short value per year.

The next problem you will encounter is that you are now liable for paying the dividends on that stock to the lender. Seems reasonable, right? Yes, but there’s one small problem. You have an investment expense and guess what? You don’t get to deduct it as an investment expense. You see, our government, in their infinite wisdom, taxes you on any dividends you receive but doesn’t let you immediately deduct the cost of any dividends you pay. Instead you are supposed to add the dividend payments on short sales to your tax basis, so you don’t get the tax benefit until you close the position. One would think that a dividend you pay would be like a negative dividend that offsets any dividends you receive, but the world we live in is not symmetrical. (I have no idea what happens when you short against the box and you receive dividends that you simply turn around and pay back out but we can all guess how that story probably plays out.)

As if all this wasn’t bad enough there’s also the small issue of the cash generated from the sale of the stock. I think this is one of those dirty little secrets. When that stock is sold cash comes in the broker’s door, which generates interest. Who gets the interest? There’s only one possibility – the broker quietly pockets the money. I once brought this up with a trader who actively shorts stocks and he uncomfortably admitted that this is something that you can negotiate with some brokers. He claimed to have worked out a deal with his broker to give him a portion of the interest. I tried bringing this up with Fidelity and they acted like I was from another planet. So I just accept this as an unfair cost of doing business. This is just another glimpse into the asymmetrical world we live in: sell some stock and get interest on the proceeds; sell someone else’s stock and you don’t get interest on the proceeds.

Finally, shorting is not even an option in your IRA. I guess it’s viewed as too risky for retirement money.

Given all these problems what do you do? As a first step, before you short something (as in the case of a hedge) look around for alternative plays. Is there something else you can sell that will allow you to get interest on the proceeds? For example, you might be better off selling your GE stock, which is closely correlated with the S&P 500, rather than shorting the S&P 500.

Another alternative is to buy one of the recently introduced short funds (also known as bear or inverse funds). These are ETFs that move in the opposite direction of their corresponding target index. It would seem reasonable that the pros managing these funds have access to techniques that you or I don’t, which allows them to more efficiently take a short position. I just checked the prospectus for the Short S&P 500 ProShares fund (SH) and discovered that they basically have two holdings: S&P swaps via UBS and cash. So instead of shorting the index they’ve essentially achieved the same effect by entering into an agreement with someone who wants to bet on the S&P rising. When the index goes up ProShares pays the counterparty and vice versa. This structure has a benefit to the party taking the long position: they take a long position without tying up cash. So there is an inherent efficiency in this structure, the benefits of which you would expect to be shared by ProShares. In addition, ProsShares earns interest on all the cash that they receive from selling the fund.

The other advantage to these short funds is that you can purchase them in your IRA, which is a bit ironic since they don’t want you taking short positions there.

So, owning this short fund might be better than taking the short position yourself. To check this I compared the two alternatives during a time period between dividend payment dates (to make it easy) when the S&P changed by its maximum amount. From March 27, 2007 to June 4, 2007 the S&P Depository Receipt (SPY) went up 7.87%. Had you shorted it and held cash in the amount shorted (since you didn’t use cash to buy the short fund) you would have lost 7.87%, offset to some extent by interest of .95% (assuming your money market is returning 5%) for a net loss of 6.92%. During this same time period the Short S&P fund went down by only 5.93%. So it appears that during this period of rising stock prices owning the short fund was a better alternative. What I can’t tell you is what would happen during a period of falling stock prices, since these short funds haven’t been around long enough for us to measure that. Perhaps this fund just doesn’t track the index that well. I’ll be keeping an eye on this since I recently purchased the short fund.

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