Market Timing

The bear market of the past three years is the most severe since the Great Depression. Many investors are tempted to transfer what little wealth they have left out of stocks and into bonds and real estate, which have performed well in recent years. Before making such a move, please consider the following.

Last week, the Federal Reserve Board kept its target for the federal funds rate unchanged at 1.25%. The Fed noted that much of the weakness in the economy is due to short-term problems, while longer-term economic trends are encouraging. Although the Fed acknowledged "large uncertainties clouding the geopolitical situation," it expressed no bias toward future interest rate
changes.

The fact is that interest rates are about as low as they can go. There is now far more room for them to move up than down. Rising interest rates would have a chilling effect on both the bond and real estate markets.

Due to the risk of rising interest rates, Vanguard has started warning its customers against shifting their assets from stocks into bonds. They recently cautioned that long-term bond funds could fall 20% if interest rates climb just two percent, while intermediate-term bond funds could fall
10-12%.

Real estate is also at risk. Dean Baker, co-director of the Center for Economic and Policy Research in Washington predicts that real estate values could plunge 30% if rates spike up. Even a small decline in real estate values can have a devastating effect on highly leveraged properties.

Meanwhile, stocks are less expensive now than they were a couple years ago. From September 1, 2000 to December 31, 2002, the price-to-book ratio for the S&P 500 dropped from 4.8 to 2.4. This is mainly due to the decline in equity
prices (rather than an increase in book values), since the overall market fell by 40% over the same time period. Stocks are still not cheap by historical standards, but they are more in line with past values.

The point is that every asset class has its day in the sun, but it doesn't last forever. It would be wonderful if we could simply shift our money around into the best performing asset classes. Unfortunately this doesn't
work. Market timing, even in the hands of professional investors, has been shown to augment portfolio expenses and reduce tax efficiency without increasing net returns.

The intelligent approach is to work with your financial advisor to develop a sound asset allocation strategy based on your risk preferences and time horizon. Diversify broadly within your chosen asset classes and stick to your strategy through good times and bad.

April 2003

Back to learning Center

Recommended Reading for Investors