Stock market timing never works. You’ve no doubt heard that one more than a time or two in the course of your travels.
Stock market always works. You haven’t heard that one nearly so often. But it is every bit as true. We say that timing never works because Eugene Fama showed in peer-reviewed research that stock prices fall in the pattern of a random walk; trying to predict in which direction they are headed is a futile endeavor. But Fama only looked at how prices behave in the short term. Robert Shiller showed in subsequent peer-reviewed research that there is a strong correlation between the CAPE value that applies today and the stock price that applies ten years from today. Knowing the valuation level that applies on the day you purchase an index fund permits you to identify a range of possible long-term returns and to assign rough probabilities to each point along that range of possibilities.
Q2 hedge fund letters, conference, scoops etc
Duration key in stock market timing debate
It’s the length of time over which you are making the assessment that determines whether Stock market timing works or not. The short-term variety of timing never works and the long-term variety of timing always does. It is every bit as true to say that long-term timing always works as it is to say that short-term timing never does.
What if you could only advance one of the two statements? Which is more important? Which is more true?
It’s a big deal that short-term timing never works. People need to know that. The intuitive thought is that timing would work in both the short-term and the long-term. If stock prices go to high levels, you would think that they would be set up for a big fall. That’s not so. Stock prices were sky high in 1996. But anyone who bet on them to fall in 1997, 1998, or 1999 was rudely surprised. It would make sense for short-term timing to work.
But it is shifts in investor emotion that are the primary determinant of changes in stock prices and shifts in investor emotion are neither rational nor predictable. So investors need to be reminded frequently that short-term timing never works.
However, they need to be reminded even more frequently that long-term stock market timing always works. The price that will be paid for forgetting Shiller’s powerful insight is usually going to be greater than the price that will be paid for forgetting Fama’s powerful insight.
Short vs long term timing
An investor who engages in short-term timing has a 50 percent chance of guessing right and a 50 percent chance of guessing wrong (since market prices follow a random-walk pattern in the short-term). The only cost that is paid for guessing wrong is the cost of completing transactions. It’s not a good idea to take on those costs. In the long term, those sorts of costs add up.
But an investor who over the course of an investing lifetime makes a few wrong guesses on the high side and a few wrong guesses on the low side is probably not going to end up much worse off than the investor who follows the good advice to not attempt short-term timing.
How about the investor who fails to practice long-term stock market timing?
There’s a good chance that that investor is going to pay a heavy price indeed. It is by engaging in long-term timing that investors practice price discipline when buying stocks. How much would you hurt yourself if over the course of a lifetime you never practiced price discipline when buying cars or groceries? That mistake would cost you a lot. Price discipline makes a big difference when it comes to buying anything other than stocks. And of course the evidence is that it makes a big difference when it comes to buying stocks too.
Shiller showed that stock investing risk is not fixed but variable. To say that the range of possible long-term returns changes when the CAPE level changes is to say that stocks are more risky when they are priced high than they are when they are priced moderately or low. So investors who fail to engage in long-term timing thereby insure that they risk profile that they determined is right for them will usually not apply for them.
If you determine that you should be going with a 60 percent stock allocation at a time when prices are moderate and then fail to adjust that stock allocation when prices reach sky-high levels, you are thereby placing yourself in circumstances in which you are taking on far more risk than you should be taking on. That’s not good.
Shiller vs Fama
I think that the most interesting thing to be said about the distinction between short-term timing and long-term stock market timing is what it says about what drives stock price changes. In the pre-Shiller days, the common belief was that the stock market is efficient; that is, that prices are set by the rational acts of millions of investors pursuing their self-interest in an informed way. Shiller showed that this is not so. If investors were acting rationally when they set stock prices, there would be no overvaluation or undervaluation; rational investors would always collectively set stock prices at fair-value levels. The fact that short-term timing never works and that long-term timing always works tells us that Shiller is right.
Fama’s finding that short-term stock market timing never works is consistent with Shiller’s finding that long-term timing always works. If stock prices are determined by shifts in investor emotion it of course makes sense that long-term timing works. All that is happening when prices crash is that the market is doing its core job of getting prices right in an environment in which the majority of investors refuse to act rationally by forcing prices down in the face of tremendous resistance on the part of those investors.
Conclusion
But it also makes sense that short-term timing would not work in a world in which price changes are determined by shifts in investor emotion. For short-term stock market timing to work, investors would need to be rational, It would make sense for prices to drop once they reached levels at which the long-term return on stocks was poor. But in a world in which prices are determined by shifts in investor emotion, what makes sense doesn’t matter. What matters is the emotions that investors feel. And high prices often do not make investors want to lower their allocations.
They often have just the opposite effect. High prices make investors desire stocks more than they did when they were reasonably priced. For so long as that is true, short-term timing is not going to work because it is not possible to predict price changes that are not being determined as part of a rational process.
Rob’s bio is here.
