Why The Reluctance To Use CAPE To Manage Risk?
I have been arguing the merits of market timing for 19 years now. Shiller showed that the market is not efficient, as it was believed to be in the days when the Buy-and-Hold Model for understanding how stock investing works was being developed. Valuations affect long-term returns. So the value proposition of stocks is not fixed but variable. Investors seeking to keep their risk profile constant over time MUST lower their stock allocations a bit when prices get very high and increase them a bit when prices get very low to have any hope of doing so.
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Interview With Value Fund Shah Capital
This is part one of a three-part interview with Himanshu H. Shah President and Chief Investment Officer of Shah Capital. The interview is part of ValueWalk’s Value Fund Interview Series. Throughout this series, we are publishing weekly interviews with value-oriented hedge funds, and asset managers. All the past interviews in the series can be found here. Shah Read More
An Effort At Risk Management
One response that I often hear is that adjusting one’s stock allocation in that way is not really market timing, it is an effort at risk management. There are many people who see the merit of changing one’s stock allocation in response to big valuation shifts. But the Buy-and-Holders have been so insistent in their claims that timing doesn’t work that they have turned “time” into a four-letter word. Even people who believe that it is often a good thing to do are reluctant to say so publicly for fear of being ridiculed or of upsetting their Buy-and-Hold friends. So a number of people have told me that my thinking is on the mark but that I need to avoid the use of the word “time” when making my case. The idea is that I will have more success if I promote risk management achieved through allocation shifts rather than market timing.
In the early days, I used to try to do that. I used to argue that the type of market timing that I advocate is long-term market timing and that that type needs to be distinguished from short-term market timing (changing your stock allocation with the expectation that you will see benefits from doing so within six months or twelve months). My efforts in that direction failed to impress most Buy-and-Holders. Most Buy-and-Holders believe that the case against market timing is so strong that someone who advocates it is the equivalent of a member of the flat-earth society. The case being argued is so dubious on its face that it discredits the person advancing it for him to do so. I have been told that I am a “crackpot.”
The important thing, of course, is to get the message out. The unwillingness of most investors to practice market timing doesn’t only increase risk and diminish return for those particular investors. Market timing is price discipline. When most investors refrain from engaging in it, it is as if the brakes had been ripped out of a moving vehicle. The speed at which the vehicle is traveling gradually increases until it eventually comes to be travelling so fast that the only way to stop it is to crash it. When we crash our stock market, causing many trillions of dollars of pretend wealth to disappear into thin air in the process, we contract our entire economic system in the process and cause an ocean of human misery for millions. Market timing is our friend.
So, if we could persuade people to engage in it by calling it by another name, it would make sense to do that. I have noticed, however, that market timing is still widely disparaged and stock prices are still at scary high levels all these many years later. My efforts to promote the practice through direct advocacy of market timing have not worked. But neither have the efforts to achieve similar ends through use of a softer terminology.
Does Market Timing Work?
I believe that the problem is that the question of whether or not market timing works is a fundamental one. If investors are engaged in a rational pursuit of their self-interest, as was believed in the days when Buy-and-Hold was being developed, market timing is an absurdity. Rational investors would set the price of stocks properly by the end of each trading day. If investors are often highly emotional, as Shiller has theorized, prices can remain wildly off the mark for long stretches of time. If Shiller is right, we cannot trust our portfolio statement to tell us the truth about the value of our stock holdings. At times like today, the official numbers would need to be reduced by more than 50 percent to adjust for the effect of irrational exuberance and to have them reflect the economic realities.
Most investors do not think through these matters when they make decisions about what sort of stock allocation to adopt. But they are aware of them on some level of consciousness. It is true that the term “market timing” is particularly inflammatory. Advocate market timing and a good percentage of the investors who hear your words are going to go at least a little bit berserk. The reaction will be more subdued if you advocate risk management via allocation adjustments. But the practical effect will be pretty much the same.
There’s a reason why we have gone 40 years since Shiller showed the importance of market timing (that’s what he did when he showed that valuations affect long-term returns) without his ideas catching on either among professionals or among ordinary investors. Investors like irrational exuberance! It is a very dangerous phenomenon. If investors were entirely rational beings, they would be terrified of it. But of course Shiller’s primary insight is that that is not at all the case. Investors are bundles of emotion and the higher the CAPE value climbs, the more emotional they become. We have seen the highest stock valuations in the history of the U.S. market in recent decades. So investors have become very emotional indeed. Today’s stock investor has developed a passionate love for irrational exuberance and is not fooled by efforts to attack it in soft and polite ways.
Challenging The Emotionalism Of Investors
I have come over time to believe that the most effective way to challenge the emotionalism of investors is to challenge it head on. I like to make direct statements that market timing always works and that market timing is always required for those seeking to keep their risk profile constant over time. No, most investors don’t bite the first time they hear those sorts of words. But the thing that is going to change attitudes is the next price crash and all the pain that it will cause in the event that Shiller’s Nobel-prize-winning research turns out to be saying something useful and important. At that time investors will want to know what happened to the larger half of their retirement money and clear statements of the realities will be more persuasive than efforts to state things in gentle and indirect and less clear ways.
It is true that market timing is needed to practice risk management effectively. But, for people to understand why that is so, they need to appreciate that market timing is price discipline and that price discipline is critical to the smooth functioning of every market that exists. I no longer advocate market timing in an apologetic tone. Market timing is wonderful. It is essential. We should all be celebrating it every chance we get. Market timing diminishes risk while increasing long-term returns. That’s a powerful combo that requires no apologies.
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