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This article is the third and final post in my three-part series on learning how to be a successful long-term investor. The general theme underlying all of the topics has been developing enough of an understanding of the stock market gyrations and sometimes wild ride to form reasonable expectations at the outset. Those expectations lead directly into to developing a long-term investment strategy and plan that you are much more likely to stick with through “thick and thin” because you know what is coming. Of course, you will not know the order in which the ups and downs may come, but you will have a ton of information helpful to be much less likely to lose your nerve or get overly excited.
The last topic will be about “market timing”. We will delve deeply into the concept and see how very difficult it has been in the past, and, I believe, will continue to be for the foreseeable future. Now the discussion to follow will be entirely self-contained; however, it might be helpful to take a look at the first two articles to have additional context. The opening topic was an overview of the history of stock market returns using the S&P 500 Index (dividends reinvested). Here is a link to that post:
The second topic was a discussion about the concept of risk. We explored how it is normally defined, ways that you can gauge your tolerance for risk given the information from the first post, and explored some methods/mindsets to reduce risk in your investment portfolio. Here is a link to that post:
So now, we will turn to the topic for the last article. As mentioned above, we are going to take a look at “market timing”. In general, the idea of “market timing” is to develop ways to be able to buy stocks when they are very undervalued and also sell stocks right near the market peak to avoid a big downturn. There are certain variations where an investor is not necessarily trying to time the most opportune time but trade along with the momentum of the stock market and anticipating the next movement prior to other stock market participants.
“Market timing” is notoriously difficult to do. But you will see considerable time devoted every day to financial market television and periodicals advising individual investors what trades to make. I would submit that following things and pundits on a daily basis adds to “noise” and “information overload”. Additionally, for every guest that predicts a big leg up in the market, there will be another guest later in the day who tells you that we are in a bubble and stocks will drop dramatically soon.
Another lesser talked about item is the main guests that are invited to speak on television or are quoted in financial periodicals. Typically, the guest introduction will be prefaced by this man/woman predicted the last major move in the stock market and we are so lucky to have him/her back again. While these guests are great to hear from, there is a severe amount of “selection bias”. What do I mean by “selection bias”? You will rarely see a guest brought on to be lambasted for a prediction that never came to fruition or was just flat out wrong. The vast majority of guests on television or market experts in financial articles will be the ones who made a very prescient call on the direction of the stock market.
The promise of “market timing” is still so enticing. It normally relates to the fear of losing money or the greed of just not wanting to miss the next big bull market trend upward in the stock market. However, the ability to call the market tops or bottoms has proven to be pretty much a 50/50 flip of the coin (now I am being generous at that). One of the examples that I love to give is the coining of the term “irrational exuberance”. The former chair of the Federal Reserve, Alan Greenspan, used that new term to state that the stock market was in what he thought was a bubble. Little do people remember, but he first gave the speech in December 1996 to refer to what would become the Dot.Com bubble and bust. Greenspan was proven right but the top of that bubble occurred in March 2000. I use that example because irrational activity in the markets can persist for much, much longer than you might expect.
So, now I know that some people reading this post will be able to point to experts who made the great calls or even their own calls on the direction of the stock market. Well, I will start off the discussion by showing that “market timing” is indeed somewhat possible. But it takes much longer periods of time than you might think at first. Here is how we will proceed in the analysis. I discussed how the long-term historical average of the S&P 500 Index from 1957-2018 has been 9.8%. It would seem logical then that, if stock market returns were below that average or above that average for a certain length of time, you could just do the opposite figuring that stock market returns would eventually trend back to that average (in the jargon reversion to the mean).
The problem is, as I briefly mentioned in the last paragraph, that the time period needs to be so long that it is almost untenable for individual investors to practically implement. In fact, we have to use 15-year annualized returns to illustrate the theory. So, if the stock market has been below/above trend, we will buy/sell because an inflection point has to come. Let’s take a look at it graphically to drive the point home:
In the graph depicted above, we have exactly the returns we would like to see. The blue dots are the past 15 years of stock market returns, and the orange dots are the next 15 years of stock market returns. The dots are what we would term to have an inverse relationship. In fact, for all of you somewhat familiar with statistics, the correlation coefficient is -0.857. Therefore, there is a really strong relationship here that leads us to the promise of “market timing”. Should we give up on it so early?
The problem with “market timing” is that, for any length of time less than 15 years of annualized stock returns, there really is no relationship (at least no actionable trading of stocks for your investment portfolio). Let’s take a look at the same concept in the first graph with a look at one-year and three-year current and then future returns:
Using the one-year and three-year current and then future stock market returns of the S&P 500 Index, our dots just kind of do not follow a discernable pattern. Again, for the statistically inclined folks out there, the correlation coefficients are -0.10 and -0.041, respectively. As always, we won’t get too waded down into the mathematical weeds but a correlation coefficient close to 0 means that there is essentially no correlation/relationship between the two. To make an analogy, you can think of what is the correlation between birds in your backyard and the number of jars of pickles for sale at your local grocery store? Well, there should be no relationship whatsoever. Even if there were, it would not make any sense. In our case here, there is at least some logic underlying our premise of the most recent return on the S&P 500 Index and the future returns over that same time period. As we see though, there is really nothing actionable to embark upon for individual investors to properly engage in “market timing”.
Before we totally give up on “market timing”, we can take a look at the same charts but extending the time periods to five years and ten years. Let’s take a look at those two graphs:
The correlation coefficient for the five-year chart is 0.028, so we cannot really use that long of a time period either. I will admit that the ten-year chart looks a little more promising. We have a graph that looks somewhat more like the fifteen-year graph that I started off with. In fact, the correlation coefficient is -0.276. And a negative number is what we want to see in order to try “market timing”. Unfortunately, the number is really not strong enough to not get caught. By this I mean, we can see that “market timing” would have worked from 1975-1985 and also from 1990-2001 roughly. However, 1965-1975 has a grouping of returns that don’t work and 2002-2008 has mixed results as well. Note that there are less data points because there needs to be at least 10 years of future returns in order to compare the current record of 10-year annualized returns with what the next 10 years of stock returns will end up being.
Overall, we have seen that “market timing” in the short term (even as defined out to five years) does not really have much, if any, predictive power. Therefore, if you make decisions related to “market timing” based upon how the stock market has performed in any time period five years or less, it is clearly a “fool’s errand” or incredibly difficult to do. And by the latter, I mean that you can reliably do so over more than one major change in market direction. The majority of market pundits that you will see or read about have made one correct call which is not nearly enough to judge his/her investing acumen related to “market timing”.
I will close out the discussion of “market timing” by using the Financial Crisis and ensuing Great Recession. Many folks correctly called (or were proven right without the reason for the bubble matching their investment thesis) this major stock market inflection point. They correctly saw the unsustainable bubble in housing, the rise of financial stocks, and the buildup of toxic securities like subprime loans. However, many of those same individuals never changed their investment thesis and failed to tell individual investors to return to the stock market and buy. Essentially there are still folks that will tell you we are in a bubble. Now I am not bold and/or grandiose enough to weigh in on the current value of the stock market. But you need to know that most of the people who call a wicked crash in stocks or a massive bull market do not change their investment thesis prior to the next big turn.
For example, let’s say that you learned about stock investing 10 years or so ago and decided to invest $1,000.00 in the S&P 500 Index toward the end of October 2007. And yes, this was the absolute worst time to invest in stocks. Sadly, by March 2009, you would have lost 50% of your investment and have only $500.00 at that point in time. You might feel great if you listened to someone who called the top and told you that the fourth quarter of 2007 was the absolute worse time to buy stocks. But I am willing to bet that this same person would not have told you when it was “safe” to invest again. If you knew to expect bouts of extreme volatility in the stock market beforehand, you could have kept your money in the stock market. At the end of December 2018, you would have had $1,712.36 using our 13.1% 10-year annualized return over that time. If the original market predictor of catastrophe told you to just keep your $1,000.00 in the bank you would have $1,160.54 (assuming generously that you could earn 1.50% over the ten years in your bank saving account). Adjusting the hypothetical investor who simply kept his/her money in stocks back to inflation, he/she would have $1,404.73 (assuming 2.0% inflation over the last 10 years which is higher than was actually experienced). At the end of December 2018, you would have a bit more than 21% higher in inflation-adjusted dollars than the person who just never invested (or took his/her money out of stocks right at the end of October 2007 but never returned to stocks).
Now I will admit that my hypothetical scenario would have tried the “intestinal fortitude” of the most seasoned professional investors after seeing a 50% market drop over 1.5 years. My only point with the example is that, even if you could not have held your nerve to remain invested in stocks over the Financial Crisis, the investment pundit(s) who tells you the exact top with a brilliant prediction also needs to tell you when to invest or sell again in the future (i.e. “market timing”). Rarely will you see such a prognosticator that can totally change their investment thesis to get the next call right. You are much better off abstaining from “market timing” and sticking to your long-term investment strategy. Of course, that may indeed call for selling or buying a portion of stocks at certain given points to change your investment portfolio allocation to match your risk tolerance and financial goals. But trying to utilize “market timing” to be in and out to experience hardly any losses and capture all the gains is just not realistic, so you might as well discard the entire investment strategy of “market timing”.