In my previous post, "Market Timing the NASDAQ - Part 1" I looked at the long term price trend for the NASDAQ versus its trend line and identified several periods of inversion where the index fell dramatically from highs to extreme lows. The question is whether investors and identify these crashes ahead of time and successfully time the market to avoid losses.
One of the largest drops for the NASDAQ was the Dot Com bubble crash of 2000 as highlighted on the trend chart:
We can see that the index price rose far above the trend line "fair value" and therefore must eventually correct to the downside. An investor tracking the data on a weekly basis would be able to see that the index was becoming extremely overvalued, sell out their position, and buy back in after the correction. As this data trend was developing, when would it make sense for that investor to execute the sell? The investor would have had to identify a price level above the trend line that indicates an extreme overvalue situation and trigger the sell. Of course the price constantly varies and always falls above or below the trend line to a certain degree. An investor doesn't want to constantly buy and sell their position based on normal market price variance. It makes sense to identify a range where "normal" prices lie and then see where the price exceeds those levels:
You can see that the NASDAQ price typically falls within the range on this chart with the yellow line as a ceiling and the green line as a floor as it follows the upward trend line in red. The yellow line represents a "normal" overvalue and the green line shows a "normal" undervalue. Looking at the Dot Com bubble crash of 2000 we can see the index crossed the normal overvalue limit around summer 1996. Setting a rule to sell when the price exceeds this line, an investor could have exited their position at this point where the price was around $1,200. The NASDAQ would have continued to inflate to a high of $5,048 in March 2000. Most investors might doubt the wisdom of selling at $1,200 as they watch the index continue to soar to over $5,000. Lost potential profit would be weighing on a typical investor's mind.
Our hypothetical investor would know that the price was wildly overvalued and set for a significant decline, which did eventually occur. The investor would track the price decline and then buy back in when the price hits the green line, which happens to luckily coincide with the low point of the NASDAQ of $1,139 in September 2002. Between 1996 and 2002, the investor utilizing this strategy would have realized around a 5% profit, the difference between selling at $1,200 and buying at $1,139. Of course over the 6 year span, the investor likely would have invested the $1,200 in something else, let's say one year T-bills yielding on average 4% per year. This would grow the $1,200 to $1,533 at the end of the period for an overall gain of $394 ($333 T-bill interest +$61 NASDAQ price differential) or 32.8% over the 6 year span. More importantly, the investor would have avoided investing in the NASDAQ at the highly elevated prices up to $5,000 and suffered a potential loss of 75% between the high and the low during this correction.
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