In the fast-paced world of investing, even the most rational investors may find themselves contemplating whether to sell their equities or delay investing new cash due to expected market volatility or reports of record high stock prices. This uncertainty often leads to thoughts of market timing – the practice of trying to predict the optimal moments to buy or sell investments. However, succumbing to the cognitive bias known as confirmation bias and attempting to time the market is not a sound strategy for making financial decisions. In this blog post, we will delve into the intricacies of market timing and explore the data on its effectiveness, with a specific focus on the Shiller CAPE (cyclically adjusted price earnings) ratio.
The Relationship Between Valuations and Future Returns:
An essential factor to consider when contemplating market timing is the correlation between market valuations and future returns. Historical data suggests that periods of high stock prices, as measured by the Shiller CAPE ratio, often precede lower future returns. By sorting stocks quarterly based on their valuations using the Shiller CAPE, a clear relationship between current valuation and future returns emerges. The data supports the notion that expensive stocks tend to result in diminished returns, while comparatively cheaper stocks fare better.
However, it’s crucial to take into account the hindsight bias inherent in this analysis. Sorting stocks every quarter based on past valuations allows for a distorted view, as real investors would not possess knowledge of future valuations, making such evaluations less effective. Therefore, while historical data showcases the relationship between valuations and returns, applying this information in real-time proves challenging due to the inability to accurately predict future valuations.
Hindsight Bias and Market Timing Strategies:
The concept of hindsight bias poses a significant challenge when attempting to utilize market timing strategies. Stocks may appear expensive relative to historical data, but they may still be cheap compared to future valuations, which are inherently unknowable. This presents a considerable hurdle for market timers, as making investment decisions based on historical valuations does not guarantee success in the ever-changing market environment.
To address this issue, AQR, a leading investment management firm, conducted research that adjusted for hindsight bias. They sorted stocks quarterly based on only the past 60 years of data, effectively reducing the impact of hindsight. The results of this adjusted method were weaker, indicating a less obvious trend towards lower future returns when stocks are most expensive. This highlights the difficulty in accurately predicting market movements without the benefit of hindsight.
Market Timing Strategy and Historical Performance:
Examining the performance of market timing strategies over extended periods can provide valuable insights into their viability. The AQR paper explored a market timing strategy that adjusted the weight in stocks based on valuations and tested it on data spanning from 1900 to 2015. While the timing strategy added value to returns for the full sample, it underperformed from 1958 to 2015.
This underperformance during the latter period can be attributed to stocks becoming more or less cheap for extended periods. For example, from 1900 to 1957, stocks were generally cheap, resulting in the timing strategy being heavily invested. Conversely, from 1958 to 2015, stocks were generally expensive, leading to underinvestment. The paper concludes that the ability to categorize the current market confidently as cheap or expensive without hindsight calibration proves challenging and makes profiting from such categorizations difficult.
Momentum and Missing Out on High Returns:
Another crucial aspect to consider when evaluating market timing is the presence of momentum in stock prices. Even after a signal suggests lower returns, there may still be further high returns to come. Stocks that have experienced price increases tend to continue on that trajectory, creating momentum. Selling stocks at that point means betting against momentum, which is a well-documented phenomenon. By attempting to time the market, investors risk missing out on potentially significant gains during periods of continued positive momentum.
The Impact of Missing Out on Market Returns:
It is important to recognize that a significant portion of market returns is concentrated in a relatively small number of trading days. By analyzing data from the S&P/TSX composite index, we can observe the impact of missing out on these high-return days. If an investor missed the single best trading day over a significant time period, the annualized return dropped noticeably. The consequences were even more pronounced when missing the 15 best trading days, resulting in a significant drop in annualized returns. This demonstrates that even a small number of missed trading days can have a substantial negative impact on long-term investment returns.
In conclusion, the notion of market timing as a reliable and consistent investment strategy is unfounded. Despite the apparent relationship between market valuations and future returns, the inability to accurately predict future valuations and the presence of momentum make market timing a challenging endeavor. Historical data and research consistently highlight the limitations and potential drawbacks of attempting to time the market.
Rather than succumbing to the allure of market timing, investors are better served by adopting a long-term, diversified investment approach. By remaining invested in the market, investors have a higher likelihood of capturing the market’s returns over time. Dollar-cost averaging, while statistically suboptimal as a form of market timing, can alleviate concerns associated with investing a lump sum of cash at a potentially unfavorable time.
In the end, successful investing requires a disciplined, patient, and rational approach. Nobel Laureate Denny Conaman’s words ring true: “It is very difficult to develop a true expertise in predicting the stock market.” By focusing on sound investment principles, diversification, and a long-term perspective, investors can navigate market fluctuations and work toward their financial goals with confidence.