Market Timing the NASDAQ - Part 1

Market timing is a controversial topic for stock market investors. Basically, market timing is the idea that an investor can detect when a stock or index has peaked and is set to fall, and therefore sell at that high point. The other side of market timing is then detecting when the stock or index has hit a low point and is set to rise, therefor buying back in. Successful market timing means an investor could always buy low and sell high, more or less eliminating the inherent risk of stock market investing.

Market timing requires predicting the future price of a stock or index. There are several arguments for or against whether it is possible to consistently time the market and improve return with less risk. The allure of market timing is obvious from a profit perspective. Market timing has roots in the human tendency to see the cause of past events as obvious in retrospect. As it is said, "Hindsight is 20/20". For example looking retrospectively at the 2022 rise in inflation, the reaction of the Federal Reserve, and corresponding decline in equity prices could now be deemed a fairly obvious chain of events. The covid era stimulus payments combined with supply chain disruptions created a situation where too many dollars were chasing limited goods, the very definition of inflation. The Fed is mandated to limit inflation and therefore went into a tightening phase driving down stock prices.

In this prior post I looked at the long term trend of the NASDAQ and proved that it is consistent and predictable. The NASDAQ follows an exponential growth trend with a 9-10% annual growth rate. Looking at this trend rate over the long term, we can see there are periods where the NASDAQ exceeds its expected value and periods where is falls below. We can identify several inversion points on the chart where periods of overvalue reverse to undervalue and vice versa:

I've highlighted a few of the most dramatic inversions points and labeled the actual LN (NASDAQ Price) vs the trend line expected. I am using the natural log of the NASDAQ price instead of the actual price just so the trend is linear and easier to analyze. Of course there are many "micro" inversion points on a weekly, monthly, or even daily basis. The four inversion cycles shown on this chart are the 1973 bear market crash, the Dot Com bubble crash of 2000, the 2008 financial crisis, and the most recent post-covid 2022 bear market. Could these have been predicted ahead of time and successfully market timed?

The trend line accounts for 96% of the price variance of the NASDAQ, so I propose that it represents fair value and the NASDAQ will tend to revert to this price. An analogy could be a rubber band strung between two nails. the nails represent the trend line and the rubber band is the NASDAQ actual price. If the rubber band is pulled upward, tension increases and it will eventually snap back. The same action occurs by pulling the rubber band down, it will eventually snap back up. With that perspective, the NASDAQ price was pulled way above the trendline in 2000 and an investor could likely have assumed it would fall back to the trendline and sold out of their position. They then could have bought back in at a lower price and avoided significant losses. I will look at this in more detail and see what could have happened step by step in my next post "Market Timing the NASDAQ - Part 2"