Stock Market Timing Strategies --
What Works and What Doesn't
Stock Market-Timing Strategy #1 -- Short-Term Timing.
There are some smart people who engage in short-term timing of their stock purchases. I don’t feel that I can reject the methods they use out of hand as I have not studied them in sufficient detail to do so.
My personal view, however, based on my own study of the historical stock-return data, is that short-term timing does not work.
Stocks reached extremely high valuation levels in the mid-1990s. The data was telling us that stocks were dangerous and that we should lower our allocations. The reality is that stock prices boomed in the last three years of the decade. Those who sold their stocks in the mid-1990s did not see a short-term payoff for doing so.
That’s only one case, of course. My tentative conclusion, however, is that it is not so unusual a case. One of the most important lessons of the historical stock-return data is that stocks perform in surprising ways over and over and over again.
My recommendation is that you abstain from short-term timing.
Stock Market Timing Strategy #2 -- Long-Term Timing.
Long-term timing is a different matter. The historical stock-return data indicates that long-term timing works.
Why is it that long-term timing works when short-term timing does not?
It’s because successful timing must be based on
a well-informed prediction
of how stocks are going to perform in the future. The best timing strategies are rooted in an understanding of how stocks have always performed in the past. Successful timers can’t see into the future any better than anyone else. They are taking an educated guess that stocks will continue to perform in the future at least somewhat as they always have in the past.
What is the basis for the educated guesses of successful market timers? It’s an understanding of the economic realities of stock investing combined with an analysis of the
historical stock-return data.
The economic realities tell us that stock prices can only go so high or so low because stock prices ultimately must reflect the earnings of the underlying companies. The historical stock-return data reveals to us the return patterns through which the economic realities influence stock prices in the real world.
In the short-term, the economic realities have little influence over stock prices. Stock investors can push prices up to absurd levels at times when earnings are nothing out of the ordinary, and stock investors can pull prices down to absurd levels when earnings are nothing out of the ordinary. In time, though, the economic realities prevail. In time, both the absurd highs and the absurd lows are revealed for what they are. In time, stock prices always return to levels approximating the fair value of the income streams of the underlying companies.
Imagine yourself pulling the lever of a slot machine. The economic realities that govern gambling at a slot machine favor the house. Does that mean that you have no chance of coming out ahead after ten pulls of the lever? it does not. Anything can happen in ten pulls of the lever. Ten pulls of the lever are not enough for the economic realities to assert themselves.
What are your chances of being ahead after 10,000 pulls of the lever? Virtually zero. Ten-thousand pulls of the lever are enough for the economic realities to assert themselves.
That’s how it works with stock investing too. Those who ignore the economic realities can come out ahead for one year or two years or three years or four years. The economic realities always assert themselves in the long-term, however.
Long-term timing works.
Stock Market Timing Strategy #3 -- All-In/All-Out.
An all-in/all-out market-timing strategy is not likely to work, in my view.
The problem with an all-in, all-out strategy is that, while it may be proven right in the long-term, it may be proven very wrong in the short-term. Most of us humans are focused on the short-term. Most of us humans can only take so much short-term pain before abandoning the long-term strategy responsible for it. Timers following all-in/all-out market timing strategies are the investors most likely to abandon their timing strategies just at the worst possible time for doing so.
Say that you looked at the historical stock-return data in 1996 and learned that stocks were at red-alert danger levels. Say that you took all of your money out of stocks as a result. What would have been your reaction to watching stock prices soar in 1997, 1998, and 1999? There’s a good chance that you would have given up on all that historical data jizz-jazz in late 1999 and bought stocks just at the worst possible time in the history of the U.S. stock market for doing so.
Successful market timers focus on the long-term. But we cannot afford to ignore the short-term. The long-term is comprised of a series of short-terms. We need to keep short-term possibilities in mind when developing long-term strategies.
I generally advise against all-in/all-out market timing strategies. Your aim should be to gradually lower your stock allocation as prices rise and to
increase your stock allocation as prices fall.
Stock Market Timing Strategy #4 -- Frequent Allocation Shifts.
It is a mistake to make frequent changes in your stock allocation.
The purpose of long-term market timing is to hold more stocks when they offer an especially powerful value proposition and to hold fewer stocks when they offer an unusually poor value proposition. We learn whether the price being charged for stocks is on the low side or on the high side by checking to see what
applies for the S&P index. A P/E10 value of 8 is absurdly low. A P/E10 value of 14 is fair value. A P/E10 value of 20 is absurdly high.
If you set your stock allocation when the P/E10 value was 14 and it is now 20 and you are still holding the same allocation, you are making a mistake, in my view. The risks associated with owning stocks are now far greater than they were at the time you set your stock allocation. You should lower your stock allocation to bring your risk level back to what you determined was the right level for you when you initially set your stock allocation.
Does it follow that you should adjust your stock allocation when the P/E10 value rises from 14 to 16? It does not.
As a theoretical matter, the risks of owning stocks are a bit greater when the P/E10 value is 16 than they are when the P/E10 value is 14. The reality, though, is that our tools for measuring valuation levels are not sufficiently precise to tell us whether there is a significant difference in the value propositions for stocks at those two valuation levels. If you change your stock allocation every time there is a tick upward or downward in the P/E10 level, you are going to be making too many buys and sells. You are going to be driving yourself crazy with unjustified mood swings and you are going to be incurring unnecessary costs.
The case that stocks offer a dubious value proposition when the P/E10 level exceeds 20 is rock-solid, in my assessment. The case that stocks offer a significantly less attractive value proposition when the P/E10 value is 16 than they do when the P/E10 value is 14 is not at all strong, in my assessment.
Engage in long-term market timing by all means. But please resist the temptation to get too cute in your implementation of the insights you have developed from your study of the historical stock-return data.
Stock Market Timing Strategy #5 -- Selling Stocks When Prices Exceed Fair Value.
The P/E10 value that represents fair value is 14. Should you sell stocks whenever the P/E10 value goes above that level?
The flaw in this strategy is in its implicit assumption that stocks offer a good value proposition only when they are being sold at fair value. It’s not so.
The long-term real return on stocks when they are being sold at fair value is about 6.5 percent. That’s not just a good return. It’s an extraordinary return. It beats the return offered by most alternative asset classes by a country mile. When the P/E10 value rises above 14, the value proposition of stocks is diminished. But not enough to make stocks a poor investment choice.
Stock Market Timing Strategy #6 -- Waiting Until Stock Prices Enter a Serious Decline to Sell Stocks.
There are some investors who understand that stocks are risky at today’s prices but who are holding off on lowering their stock allocations until stock prices enter a serious decline. The thinking here is that the investor can continue to take advantage of any price rises that take place before we begin traveling in earnest the road back to reasonable valuation levels.
Color me skeptical.
It’s certainly true that stock prices could head upward from these price levels. So there is a potential loss that might result from lowering your stock allocation today. The more important reality is that the potential downside is today far greater than the potential upside. If the risk level for your overall portfolio is too high, you should be taking steps to address the problem immediately.
The thought behind the strategy of waiting until prices enter a serious decline to sell stocks is that it is possible to distinguish a serious decline from a non-serious decline at the time the decline is taking place. I don’t think it is possible. It seems to me that those following this strategy are following a form of short-term timing.
The question that those who follow this strategy need to ask themselves is -- How far would stock prices need to fall to persuade you that the price decline is a serious one? Say that your answer is “10 percent.” Stocks fall 10 percent and you sell. Then stocks go up 20 percent. Do you buy?
I don’t recommend mixing short-term timing strategies with long-term timing strategies. Long-term timing works and short-term timing does not work. Mix the two and you’ll end up with a strategy that might work and that might not. That’s a dangerous path to travel, in my view.
Long-term market timers do not try to predict short-term results. We instead focus on value propositions. When stocks represent a good buy for someone in our circumstances, we buy. When stocks represent a poor buy for someone in our circumstances, we sell until we get our allocations down to a level at which the stocks we own provide a solid value. We don’t even try to guess how far up or how far down any particular upturn or downturn is going to go before exhausting itself.
Stock Market Timing Strategy #7 -- Waiting Until Stock Prices Hit Their Bottom Before Buying.
Stock prices have been at today’s level (this article was written in October 2006) three times before in the history of the U.S. market. The average percentage loss suffered on those three earlier travels to la-la land was 68 percent. When stock investors learn that they made a mistake buying overpriced stocks, they usually overreact. They continue to sell after stock prices have reached fair value, sending them down to price levels as absurd on the low side as they earlier were on the high side.
So is it smart to hold off on buying stocks until the P/E10 value drops to 7 or 8 or 9?
Not in this boy’s opinion.
The long-term returns that apply when stocks are purchased at a P/E10 value of 7 or 8 or 9 are truly mouth-watering. I can’t blame you for hoping that we see those sorts of prices someday in the not-too-distant future. I don’t recommend holding off on purchasing stocks until we get there, however.
Again, your focus should be on value propositions. At a P/E10 value of 14, stocks offer an outstanding value proposition. It is true that the historical record suggests that stocks you buy at a P/E10 value of 14 may later be selling at a P/E10 value of 7. You may suffer a 50 percent loss on shares you purchase at fair value as we head downward from the sky-high prices that apply today to the rock-bottom prices that the historical record suggests we may be seeing in the not-too-distant future.
That shouldn’t concern you too much. If you buy stocks when they are selling at a P/E10 value of 14, you are likely to see an astounding long-term return from that purchase. A potential 50 percent price drop is the price you pay to obtain that astounding long-term return. If things play out that way, don’t let it bother you too much. Keep your eyes on the prize.
It does make sense to hedge your bets. It seems to me to make sense to start buying stocks when the P/E10 level drops below 20, and then to buy more when the P/E10 value hits 14, and then to buy even more still if the P/E10 level hits 8. That way you are covered for all possibilities. If prices shoot upward after the P/E10 value hits 14, you will be in on the action. If prices continue downward after the P/E10 value hits 14, you will not be hurt too bad and will be positioned to reap the gains that come from increasing your stock allocation at a time when rock-bottom prices apply.
Stock Market Timing Strategy #8 -- Selling All Stocks at High Valuations.
Performing a regression analysis of the historical stock-return data tells us that there is a good chance that the S&P index will provide an annualized real return of 1 percent or less over the next 10 years. Should you sell all of your stocks?
I see that as an over-reaction in the typical case (there are exceptions). The 10-year return on stocks is not likely to be good. The 20-year return on stocks is not likely to be good. But the same historical data that tells us that the 10-year return and 20-year return are not likely to be good also tells us that the 30-year return is likely to be not so bad. The 30-year return for a purchase of the S&P index made at today’s prices is likely to be a bit above 5 percent real. Not too shabby.
Why not keep 30 percent of your portfolio in stocks even at today’s prices? In the event that stock prices go up in the short term (don’t think it cannot happen), you’ll be glad you kept some skin in the game. In the event that we see a 50 percent price drop, you’ll only experience a 15 percent loss in your total portfolio value. That probably won’t be a devastating enough hit to cause you to sell the shares. So long as you don’t sell when prices are down, you will someday far out in the future see a solid return on that investment.
Valuation-Informed Indexing aims to avoid the extremes both of the “Stocks Are Always Best So Valuations Just Do Not Matter!” School and of the “Prices Have Gone So High That the Sky Will Soon Be Falling!” School. Ours is an investing approach that disdains exclamation points.
We’ve seen prices like those that apply today before. Millions of investors were wiped out as the result of tall tales that were told about how stocks perform in the long run on those earlier trips to la-la land, so we naturally want to avoid the sorts of illusions that fueled those earlier price crashes. Let’s not get swept up in the opposite sorts of emotions either, though.
Successful market timers keep their heads about them when their fellow investors are losing theirs. Successful market timers reject the most extreme claims of both the bulls and the bears. Perhaps we should think of ourselves as dolphins, creatures known for applying a measure of intelligence to the task of living life in an emotionally healthy way. Valuation-Informed Indexing is an investing approach for those capable of seeing the appeal of a moderate course.
Stock Market Timing Strategy #9 -- Rewriting Your Plan Each Time Conditions Change.
It is a mistake to develop your market-timing strategy on the fly. When prices fall, most investors will respond emotionally. The media will respond emotionally. Most experts will respond emotionally. Long-term market timing works because it is an investing approach that is rooted in reason rather than emotion. To avoid getting caught up in the emotion of the moment, you need to prepare in advance a plan that guides you as to how to respond to all possible scenarios.
It is best to put your long-term market-timing plan in writing. It is best to be as detailed as possible in preparation of it.
Stock Market Timing Strategy #10 -- Inflexible Implementation.
Valuation-Informed Indexing is a new approach. We are developing the
rules of the road
together each day in the discussions that we have at this site and at all of the various Retire Early boards. While we want our plans to be as detailed as possible and while we generally want to stick to our plans rather than allow ourselves to get caught up in the emotion of the moment when prices start to fall hard, we need to be realistic about the limitations of our knowledge of this new approach to long-term investing. When we discover errors in our understanding of the economic realities, we need to adjust our plans to reflect our revised understanding. We need to remain flexible in implementation of our market timing plans.
Is it paradoxical to say both that we should stick with our plans rather than allow ourselves to be influenced by the emotion of the moment and also to say that we need to be flexible in the implementation of our plans so that new discoveries can be reflected in our investing decisions? It is.
Life is paradoxical at times. Humans are paradoxical at times. How could investing strategies designed to work in real life for humans not evidence a measure of paradox as well?
Good luck with your long-term market timing strategies, my fellow dolphin!
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