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Should I Use a Market Timing Signal to Decide to Make a Trade?

Wouldn’t it be great if investors had a clear sign about the trading decisions they should make? A market timing signal attempts to provide just that. Market timing signals can help traders make money during uptrends and protect cash during downtrends. But do they always work? Here’s what investors need to know.

Key Takeaways:

  • A market timing signal is an indicator investors can use to try to time the market when they make decisions about buying and selling.
  • Traders can use market timing signals for any kind of trading vehicle, including common stocks and more.
  • A wide variety of market timing signals exist, along with a variety of track records for these different signals.

What Is a Market Timing Signal?

Image via Unsplash by chrisliverani

Traders try to time the market by using a system of buy and sell signals. Various methods exist to create mechanics behind a market timing system, and methods can use signals for short-term moves or for long-term investments. Stock market timing models draw on applied mathematics, proven technical indicators, pattern recognition, predictive analytics, and even artificial intelligence to help investors make money when the market is trending upward. These models also help investors protect and grow investments when the market is trending down.

It’s possible to look for signals to time trades for any type of trading vehicle, like:

  • Exchange-traded funds (ETFs).
  • Forex.
  • Futures.
  • Stocks.

When traders employ market timing strategies, they are looking for a way to trade the stock market only when there are conditions that are most favorable for trading. If a trader finds a market timing signal for a bull market, for instance, they can decide to enter (buy) into stocks or other trading instruments that could potentially earn them money when the prices rise. Using market timing signals in this way could boost the probability that a trade will be successful. However, trying to time the market to buy into a downtrend can be trickier.

A market timing signal will not predict the market’s future price action, but rather will use confirmation of a move that has already started.

As a general guideline, most markets tend to trend in a way that they create trading patterns. Traders can take advantage of these trends when they know what to look for. For instance, the stock market very rarely moves up in a straight line. Instead, it tends to go up and down in trends. When investors use market timing signals, they try to be in the market for up trends and out of the market when it weakens. All in all, it’s possible to time the market and use market timing signals as a part of overall strategies and trading methods.

Benefits and Downsides of Using Market Timing Signals

Market timing strategies have existed since the inception of markets. Investors use market timing signals and strategies to forecast trends in bull markets, bear markets, and everything in between.

The goal when investors use market timing signals is to fully invest in bull markets while avoiding the drawdowns that happen during bear markets.

Along with that big potential benefit of successfully employing a market timing signal comes some risks. One big issue with these indicators is that if the signals always reliably worked, every participant in the market would use them. But when it comes to the stock market, the odds of success change as people make trades. The simple act of everyone using the same system would render the system useless in the end.

Examples of Market Timing Signals

Of course, every investor ISN’T using the exact same system of signals to inform their trading strategy. So, let’s take a look at some market timing signals traders have used in the past:

Dividend Yields vs. Bond Yields

Investors have looked at dividend yields in comparison to bond yields to inform trading decisions. The strategy holds that when dividend yields are higher than bond yields, investors should own stocks, but when bond yields exceed dividend yields, they should own bonds. Simple, right?

Well, not exactly. Let’s dive into some historical details.

The S&P 500 consistently yielded more than the 10-year Treasury bond between the years of 1928 and 1958, typically in the realm of 2-5% more in that period. Investors considered owning common stock risky during that time, so a yield on stock that was greater than government bonds was needed to make investors actually go out and buy equities instead of those treasuries.

Then, in 1958, the 10-year bond yield exceeded the S&P 500 for the first time ever. Investors might have considered this a market timing signal that they should get out of stocks and instead direct their capital into bonds while waiting for the market to normalize back to yield on stocks exceeding the yield on bonds.

If investors followed that timing strategy based on stock and bond yields, they would have ended up waiting a long, long time to start investing in stock again — it took nearly 50 years before the 10-year bond yield again went below the S&P 500’s dividend yield. Staying out of stocks for the 50 or so years after 1958 probably wouldn’t have worked out well for investors. That’s not to say investors can’t incorporate this market timing signal into an overall strategy, just that they should proceed with caution (as with any market timing signal).

10-Year Minus 3-Month Yield Curve

Investors can also look at the yield curve as a market timing signal. Traders utilize this signal by measuring the difference between 1-year Treasury bond yields and 3-month Treasury bond yields.

If the market is functioning well, investors usually see a yield spread between 1% and 3%. This reflects the spread that an investor will require to compensate for the risk of holding bonds with maturity further into the future.

The warning sign this market timing signal provides occurs when the yield curve inverts. This happens when the long-term 10-year yields drop down below the short-term 3-month yields.

A yield curve inversion can offer a meaningful signal because this indicator happened before nine recessions in the United States since the 1950s. Besides one false positive signal in 1966, this market timing signal has boasted a very good track record.

As recessions usually lead to significant declines in the stock market, many investors turn to the yield curve inversion as a market timing signal to lighten their exposure to the stock market. This can help avoid any declines that are about to come.

It’s worth noting that while an inverted yield curve has historically signaled that a recession is coming, it doesn’t have a stellar track record in terms of showing WHEN that recession is going to start. Historical yield curve inversions have happened anywhere between seven and 24 months before a recession actually starts.

Baltic Dry Index

The global financial crisis that hit in 2008-2009 led to another leading economic indicator. The Baltic Dry Index, or BDI, functions as a composite of freight shipping rates. The BDI is thought of as an indicator of the shipping market in general. So, what does that have to do with stocks? Many think the BDI can also give insight into where the global economy is heading.

The BDI rallied along with global markets between 2006 and 2008. When stock markets plunged around the world during the global financial crisis, the BDI followed suit. Then, both the stock markets and BDI showed significant signs of recovery in 2009.

But in 2010, the BDI started to show signs of weakness again. Investors wondered if this was a signal that the stock market was again heading toward a decline. Well, as it turns out, the BDI stopped working as a good market timing signal that year thanks to tons of ships being delivered. That decimated shipping prices and dragged the index to new lows over the better part of the next decade. The stock market overall didn’t follow this same trend.

Should Investors Use Market Timing Signals?

T he history of the stock market goes hand in hand with indicators, many of which have a spotty-at-best track record. Still, investors have turned to many different market timing signals to try to forecast the market for the short term. They’ve gotten mixed results.

So, should traders actually use a market timing signal to make decisions on trades? The key here is understanding that no stock market indicator is perfect. However, they are worthy of investors’ attention. Traders can take note of what these indicators say and proceed with that knowledge and awareness — and with caution.