VI. The Dangers of Market Timing

Key take-aways

  1. Good points to exit and re-enter the stock market are only clear in hindsight. In real time, they are extremely difficult to judge.  And you need to be right twice, on exit and on re-entry.
  2. Fixed rules based on price moves or even overall market valuation are ineffective and often counter-productive. Using “gut instinct” is even worse, as it essentially relies on emotional judgments which are likely to conspire against you.
  3. The negative effects of bad market timing are pernicious—they absolutely will eat into your returns and the money you would otherwise have been compounding.
  4. Better just to have a long-term plan and stick to it.
515227966

Market timing is like the Sirens song in the Odyssey, luring you in with sweet sounding music only to dash your ship on the rocks.

In the last section, as you were looking at the graph of the S&P 500 from 1995 to 2015, the following thought probably crossed your mind.  “Duh, the thing to do was to get out of the stock market in March 2000 and get back in in December 2002 and once again out in October 2007 and back in in March 2009.”  In hindsight, by doing so, you would have avoided declines of -49% and -57% respectively, vastly improving your total return over the entire 20 years, not to mention saving yourself months of anxiety.

Certain professional traders engage in this type of market timing, and a small few of them may even have a knack for it.  But, in truth, this type of thinking is downright destructive.

In two words, here’s the problem: “in hindsight.”  In hindsight, your vision is always 20/20—the points to have sold and bought are crystal clear.  But in reality, you have to make these decisions in real time.  In real time, the picture is not clear, but rather very muddy.  And to make matters more difficult, you have to make the right decision not once, but twice: both as to when you sell and when you jump back in and buy.

In real time, no one posts a sign that it’s time to get out or blows an all-clear horn to get back in.  Yes, you will no doubt hear plenty of advice from pundits on TV and the radio, in newspapers and even at cocktail parties.  Each and every day.  These various pundits will nearly always offer up conflicting opinions—some bullish, some bearish—and they will support their diverging points of view with convincing arguments.  So, at the end of the day, you have to make “the call.”

On What Basis Do You Make “The Call?”

You could use rules based on price moves, for example a “stop-loss” whereby every time the S&P 500 has declined 5%, you automatically pull out.  As we saw in the last section, over the most recent bull market that started in March 2009, you would have sold at a dozen different points in time, about every six months.  Perhaps, then, a higher threshold, like a 10% decline, might work better.  The market hit this four times.  But as it turned out each would have been a better time to buy, not sell.  Bottom line, using such signals, you would have missed much of the nearly 200% price appreciation in the S&P 500 over this seven-year stretch.

Here’s a a better (but still flawed) approach.  Use some objective, fundamental parameter, like the overall valuation of the market, to govern whether you were in or out.  A commonly-used and very good measure of valuation is the Price to Earnings (or P/E) ratio, which relates the market value of a stock or index to the current earnings of the company or portfolio of companies.  The higher the ratio or multiple, the more expensive the stock or the overall market.  The idea is to have a rule that says if the market gets too expensive, you sell, and wait on the sidelines until valuations have returned to reasonable levels.  I in fact maintain a model of “fair value” for the market, using long-term trends in earnings and an appropriate multiple based on recent inflation levels.  Here is a graph of that model.

figure-13
Constancy Investors analysis: Fair Value Trend Lines are derived using the following methodology. Trend-line EPS is extrapolated two ways: (1) at the long-term compound average growth rate of 5-yr average EPS, and (2) on rolling 10-year growth rates of 5-year average EPS. Trend-line EPS is capitalized by a multiple using the “Rule of 20”, whereby the multiple each year is calculated by subtracting the average inflation rate over the last 5 years from 20. Source data: S&P, Bloomberg.

Unfortunately, this fair value approach is also counter-productive.  Here’s why.

Let’s look at the period when using such a rule would have been most helpful, the stock market bubble that peaked in 2000.  Say our rule is to get out of the market when it is 20% above fair value, recognizing that our model is an imperfect estimate.  With such a rule, we would indeed have avoided the entire nearly 50% decline in the S&P 500 from mid-2000, at which point the index was priced over twice this model’s estimate of fair value!

But we would have side-stepped the entire 150% run-up that preceded it as well!  Roller coaster rideBecause the S&P 500 was actually 20% above fair value on this model around September 1995.  And it remained above that threshold until around June 2002.  Over this entire seven-year period, the S&P 500 returned nearly 70%, despite having been cut in half over the last two years.  Bottom line, stocks climb over time around fundamental trends of fair value, but they often stray badly from the steady path—again, more roller coaster than railroad.  Given the utter unpredictability of when stocks climb and drop, it is better just to go along for the ride. Look how much fun these two are having!

Before we move on, let’s re-visit the topic of the last section, the role of your emotions in investing, specifically as they relate to this idea of market timing.  This is especially important to do, because in practice, most market timing doesn’t follow some logical rule, but rather relies on “gut instincts.”  Which is really to say, emotion.  Flat out, your emotions are going to conspire against you.

Your natural inclination is to head for the hills when the news is terrible, and part of that terrible news is itself the stock market dropping.  We have already seen that even in a rules-based approach, “stop losses” after 5% or 10% declines more often than not prove to have been better times to have bought than to have sold.  As we discussed last section, when we are living stock market declines, they are scary.  And these fears are going to exacerbate this tendency to zig when you’d be better off zagging.  Similarly, on the other side of the coin, when the news is great and stocks are marching up, it is not much going to occur to you that now is the time to step out.

Investors who engage in this type of knee-jerk selling and buying based on prevailing sentiment relentlessly lock in losses and buy in at higher prices.  The negative effects of this market timing are pernicious—subtle and difficult to measure, but they absolutely will eat into your returns and the money you would otherwise have been compounding. 

You can see a measure of this shortfall in the Chasing Performance section under the Exercising Common Sense tab that follows.

Again, better just to have a long-term plan and stick to it.