How’s Your Timing Model Working?

Workers at Chrysler walked out today in their first nationwide strike in years. Crude oil prices notched another all-time record high in September. The housing slump appears to have gone from bad to worse as a leading homebuilder recently reported a quarterly loss in excess of half a billion dollars. Homeowners are facing higher interest rates this month on tens of billions in sub prime adjustable-rate mortgages. In recent days, the dollar has fallen to one record low after another against the euro. Former Federal Reserve Chairman Alan Greenspan worries that inflation and interest rates are headed higher. The Bank of England recently provided emergency funding to rescue a troubled UK mortgage lender, the first such action since the British central bank became independent in 1997.

Worried? Not a bit—you sold all your stocks near the top in mid July just before the turmoil in global credit markets sent equity investors stampeding for the exits. It was easy to see that stocks were set for a nosedive, you remind yourself. In mid June, one of the sharpest firms on Wall Street revealed staggering losses at two in-house hedge funds specializing in fixed income instruments. A week later, a California brokerage firm shut down after losses on mortgage-related securities. And as the stock market climbed to all-time record highs—July 19 for the S&P 500® Index—the news background included credit rating cuts by Moody's on hundreds of mortgage-backed securities and a 40% drop in orders from a leading homebuilder. Obviously, it was time to sell stocks and enjoy the prospect of buying them back when discouraged investors began to unload them at fire-sale prices.

Or not.

Stock markets around the world dropped 10%-15% from mid July to mid August as credit market worries were suddenly front-page news. But in subsequent weeks, stocks edged higher and have now recouped most of their losses. In the absence of perfect timing, an investor who sold near the peak in July will likely have to come up with extra cash to re-establish previously held positions, in addition to the potential capital gains tax burden. As of October 9th, broad-based global stock indexes are at their all-time highs, and the Emerging Markets ETF has set new records, eclipsing the previous high-water mark set on July 16 by approximately 18%.

I have no idea which path stock prices will follow from here, but their behavior in the summer of 2007 offers yet another illustration how predicting future events is much easier than determining how markets will respond to them.

Thanks to my colleagues at Dimensional.

Stay Happy,
Mike A