“I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
A Correction is Coming
The internet is abuzz with talk about the looming bear market. I’ve seen this mentioned on so many different financial sites, blogs, forum posts, etc. There’s a correction coming, and some of the more confident investors have even begun liquidating their positions in the hopes of buying back in at a better price in the future.
It’s not hard to predict that a correction is coming, I’ll make that prediction right here and now. There’s a correction coming. Stocks are really overvalued right now, the market is at an all time high, and it’s really hard to find value anywhere, <insert more buzzwords>. There’s only one problem with all of this, in that it has absolutely no predictive power. It’s like saying there’s a storm brewing. I’ll be right… eventually. No matter where I say it, I’ll be right eventually. The problem is if you ask me WHEN, and that’s surprisingly hard to get right.
Let’s look at some of the common reasons people have cited:
Markets are at all Time Highs
So? The S&P 500 is at 2144 (high of 2193 hit sometime in the last few months) as of the moment I flipped over to Google to check while writing this. Let’s backtrack to 1950 or so and you’ll find the S&P 500 sitting around 17 or thereabouts. That means there have been literally thousands of separate instances where the market has been at an “all-time high”. That’s kind of how this investing thing works, the market grows and posts new highs. If you get the scared off every time it makes new highs and sell off your positions, you probably aren’t gonna do all that well with your investments.
Markets are Overvalued (ie. High Shiller P/E or CAPE Ratio)
Another number being thrown around is Shiller P/E or CAPE ratio with numerous people citing the current high as a sign that the market is overheated.
To steal directly from wikipedia:
It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns. It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events.
So right off the bat, it’s not a predictive indicator. It can’t tell you if and when a correction is coming, how long it’ll take, and when you should cash out or cash back in. That isn’t the point of the ratio. The point is to give you an idea of likely returns over the next couple of decades in super rough, hand-wavy terms.
Let’s start by walking through an easy example of why taking these to heart can get you into trouble:
At present, we’re at a Shiller P/E ratio of a little over 25 right now, which is historically very high. To find some similar examples, we can look back December 1995 or so when the Shiller P/E ratio first climbed over 25 and the S&P 500 was at about 615. Assuming you take this as a signal that the market is overvalued and move to cash, you miss out on the climb up to 1500 but you also avoid the crash back down. You have a tiny tiny window of opportunity back in the early 2000’s to buy back in since the Schiller P/E dips below 25 for more than a few months consecutively, but the S&P 500 is sitting in the 900 range now, 50% more expensive than when you cashed out and you also lost out on 7 years of dividends (ouch).
If you missed that window of opportunity, you can buy back in again in 2008-2009 as the ratio comes all the way back down to 15. Keep in mind though that you’ve missed out on nearly 1 1/2 decades worth of dividends at this point! If you get in immediately as the Shiller P/E drops below 25 you’ll end up having to buy the S&P 500 for around 1380. But let’s assume you have inhumanely good timing and managed to buy right at around the lowest point of 700 or so in March 2009.
Either way, at this point you’ve spent about 14 years earning a negative return 😛
This is just a simple example of how catastrophically wrong it can go for you. In this case we traded a 138% gain in order to bag a -3% loss, not the smartest move. But as we see in the next section it’s actually not all that uncommon to swap out a decent return for a sub-par one simply by being out of the market and thus missing the big moves up.
Let’s go into a bit more depth and examine a few strategies other bloggers have suggested. We’ll graph their returns over a 20 year period. I wrote a quick market simulator in python that let me create custom strategies, and the S&P 500 historical data was sourced from Robert Shiller’s site (link).
The 1st will be a simple buy and hold, dividends reinvested.
The 2nd we’ll only be in the market when Shiller P/E is less than 25.
The 3rd will be buying on dips: We’ll look for a correction of 10% from the previous high to signal a buy, and sell once we recover and make a new high.
* Note: In each of these cases, the investor is in cash when out of the market.
As you can see here, none of these fared particularly well against an investor that bought everything in January, 1995 and didn’t look at their account for 20 years. Checking up in 2015, this lucky investor sees that their initial investment has grown to over $63k!
For all their patience, careful timing, and analysis though, the other 2 have only succeeded into saving themselves a lot of extra money :(It’s not hard to see why, both active investors ended up out of the market for long swathes of time, often when the market was climbing. They did avoid a lot of the volatility the buy and hold investor experienced, but at the cost of a significantly lower total return.
Timing the market is hard, which is why so much of the advice is to just buy and hold. You’ll probably do extremely well just buying and holding, whereas you’ll probably do pretty s**t if you try to get too smart with things.
Some may cynically point out that so far this is pretty anecdotal, seemingly cherry picked data to make a specific point that timing is best left to gamblers. So let’s go a bit deeper, and run a comparison of the return of every single 10 year span starting from 1950. For each of these, we’ll compare the return of buy and hold vs the other 2 strategies and graph the percentage difference in return. Positive values will represent when market timing beat buy and hold, while negative will represent when you’d have been better off just letting things ride.
Really mostly more of the same. A few instances here and there where buying on dips or looking at the CAPE ratio yielded a slightly better return over a decade, but most of the time the difference was pretty drastic. This is by no means an exhaustive analysis of every possible strategy vs buy/hold, but it does illustrate our point nicely. It’s actually really difficult to come up with a way to beat a vanilla sitting-on-your-ass-and-doing-nothing strategy, which is why it often comes so recommended from the pros.
Maybe you can come up with something that you’re confident works, some elaborate combination of indicators to clearly show an optimal buy/sell situation, but my guess is that what you’ve actually done is just over-fitted the data.
Being Wrong is Easy
The problem that every market timer faces is that they’re gambling against something that generally trends upwards, and continuously pays out. Moving to cash to wait for that opportune time to jump back in carries a double risk of potentially being forced back in later at a higher price, and simultaneously having your purchasing ability eroded since the market would have been paying out dividends or additional shares to someone fully invested.
As a gross simplification, the market moves in 1 of 3 ways: up, down, and sideways.
If the market moves up, you lose twice. The most obvious of which is that you’re forced to buy back in at a higher price. The 2nd is that for the entire duration you sat on the sidelines, you collected no dividends.
If the market moves sideways, you still lose out vs being invested since you collect no dividends and thus your future return will be lower. At present the S&P 500 yields a little over 2% while the TSX yields a little under 3%. Staying on the sidelines for 1 year means you have to overcome a 2-3% difference. At 2 years you’re looking at 4-6%, etc.
If the market moves down, then you finally net a win, assuming it moved down faster than the dividends collected.
On top of this, someone timing has 2 challenges, finding the right time to get back out, and then needs to figure out the right time to get back in. This isn’t easy, you could call the top perfectly and move into cash only to watch the market pull back and then blow past that old high.
What am I going to do?
Stay invested and continue making contributions. That’s pretty much it. I’m a long term investor and it doesn’t make sense for me to suddenly start playing a different game just because the market might correct at some vague and ill-defined point in the future.
Keep in mind this terrible example of anti-timing. Say I was the poor schlub who put his entire life savings in the market in July 2007. No continued contributions, no dollar cost averaging, nothing. All one big lump sum at the absolute peak of the market. Pretty much the worst possible time before the 2008 crash. So assuming I just held on and continued reinvesting any dividends received, in around August/September 2012 I’d have hit the break even point (the market isn’t *quite* back to the original high, but the reinvested dividends have made up for it). Not awesome, but not the end of the world, took about 5 years to claw my way back there. Fast forward a few more years and as of January 2016 I’m up over 60% on the original investment.
This isn’t a total condemnation of market timing, I’ve heard that apparently a few (very few) people can make it work for them. But there’s a high cost to being wrong, and it doesn’t require any work other than sitting on your butt in order to be “pretty right”.
Whether you’re an index investor adhering to the 4% rule or covering expenses via dividends, the expectation is that the research has taken these kind of corrections into account. They’re bound to happen and even expected. Just stay cool, weather the storm, and keep contributing. Chances are it’s the best thing you can do for your portfolio.