Does Market Timing Becoming Less Important The Longer Irrational Exuberance Remains In Place?
I’m a big believer in market timing. Not short-term timing, to be sure. To engage in short-term timing is just to engage in guessing games as to when price shifts will arrive, which is foolishness. But long-term timing is a very different story.
The peer-reviewed research that I worked on with Wade Pfau shows that long-term timing (adjusting your stock allocation in response to big price changes for the purpose of keeping your risk profile constant over time) always works, permitting investors who employ it to achieve higher long-term returns at greatly reduced risk.
Get The Full Ray Dalio Series in PDF
Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues
Q4 2022 hedge fund letters, conferences and more
Gates Capital Management Reduces Risk After Rare Down Year [Exclusive]
Gates Capital Management’s ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
The Penalty For Market Timing
The Buy-and-Holders don’t buy the case for long-term timing. They argue that it is not possible to say when prices will turn (which is correct) and that stock prices always go up again after they crash (also correct).
The mistake that the Buy-and-Holders make is to believe that it is possible to stay the course (one of their favorite injunctions) by sticking with the same stock allocation at all times even though changes in the CAPE value translate into changes in the riskiness of owning stocks. Staying the course in a meaningful way requires market timing.
But market timing can test an investor’s patience. Robert Shiller published a paper in 1996 arguing that investors who were going with high stock allocations in 1996 and who failed to lower them in response to the crazy high prices of the day (not quite as crazy as the prices that apply today) would live to regret not doing so within 10 years.
He presumed that prices would fall hard within 10 years because that is what the historical record showed had always happened in the past. That’s not precisely how things plated out. Prices did not fall hard until September of 2008. We only have 150 years of good records of stock prices. That’s not enough to provide us with return data that covers all possible scenarios.
So market timers can get surprised by how long they have to wait until stock prices turn in the direction in which they are anticipating them to turn. The market timers need to put the money they took out of stocks into some other asset class during that time and the other asset class is usually going to be one that offers a return lower than the 6.5 percent real average long-term return offered by U.S. stocks.
There’s a penalty for going with a market timing strategy that takes too long to pay off. Fear of having to pay that penalty scares lots of Buy-and-Holders away from trying their hand at market timing.
An investor who is deeply concerned about having to pay that penalty is not cut out for market timing. The penalty is potentially a real thing. I don’t believe that it is nearly as bad as the Buy-and-Holders make it out to be.
But an investor who tries his hand at market timing and then abandons the strategy just before prices shift finds himself in the worst of all worlds – he suffers the penalty and then never sees the rewards that would have countered it if he had only stuck with his strategy (if he he only “stayed the course,” so to speak).
Don’t engage in market timing unless you possess a deep understanding of why it always works and know yourself well enough to know that you possess the courage of your convictions.
The primary reason why the penalty is rarely as big as the Buy-and-Holders imagine it to be is that they fail to appreciate the amazing rewards that market timers receive on the other side of the price break. Stocks are today priced at not-quite-but-nearly two times their fair value.
Buy-and-Holders often tell themselves that they are willing to risk a 50 percent price drop in exchange for being able to stick with a high allocation in a high-return asset class. To see why this is a faulty analysis, you need to consider what it is that causes stocks to rise to such crazy price levels in the first place.
A Get Rich Quick Urge
It is human psychology that does that. We all have a Get Rich Quick urge within us that makes us want something for nothing. That’s why we have bull markets, when prices become unhinged from the economic realities, instead of slow-but-steady markets producing boring returns of 6.5 percent real year after year after year.
What causes bull markets to collapse is a turn in the psychology that produces irrational exuberance. When irrational exuberance disappears from the scene (it always does), it is not replaced by neutral emotions. It is replaced by irrational depression.
The long secular bear markets that follow long secular bull markets don’t pull the CAPE value down from 30 to 17. They eventually pull it down to 8 and they let it remain there for a good number of years.
So the losses caused by failing to engage in market timing are usually much bigger than what the Buy-and-Holders anticipate. The other miscalculation they make is to underestimate the benefits of market timing.
Stocks purchased when the CAPE value is 8 offer a 10-year annualized return of 15 percent real. You want to have as much money invested in stocks at CAPE values like that as possible. But of course those who followed Buy-and-Hold strategies may have seen their stock portfolios depleted by a good bit more than 50 percent before those juicy long-term returns become a live possibility.
Because the market timers retained more of their assets when prices were crazy, they have more to invest in stocks when prices are amazing.
What if the irrational exuberance remains in place too long? What if the crazy bull psychology just refuses to break?
That can happen. The hard part of following a market timing strategy successfully is sticking to your guns when it looks like the crazy bull psychology is never going to break.
This is why I do not think it is a good idea to go with an extreme stock allocation even when prices are very high indeed and even when those high prices have been in place for a long time indeed. An allocation strategy that calls for 60 percent stocks when prices are moderate, 30 percent stocks when prices are crazy high and 90 percent stocks when prices are crazy low offers enough flexibility to get the job done perfectly well.
You would enjoy a bit more gains if you went with more extreme allocations. But extreme allocations are hard to stick with when it takes longer for prices to shift than you anticipated. And losing your nerve is a sure way to place yourself in circumstances where you pay a big penalty for market timing.
Market timing based on dramatic shifts in valuation levels makes all the sense in the world. But moderate market timing strategies are far more likely to pay off. The 150 years of historical return data that we have to review is not enough to permit us to get super cute re this stuff.
Rob’s bio is here.
Comments are closed.