Stock prices do not follow a random-walk pattern, as they would if the market were efficient (as it is presumed to be by Buy-and-Holders). They follow a hill-and-valley pattern. Each bull/bear cycle begins with prices at rock-bottom lows (a CAPE value of 8) and sees them increase gradually over several decades, only to crash after they have hit insanely high CAPE values of 25 or more.
It would be hard to accept that this hill-and-valley pattern is coincidental. It has reasserted itself over and over again over the course of the 150 years for which good records of stock prices are available. We now have four complete or nearly complete bull/bear cycles on record and the same pattern (but not precisely the same pattern — there are significant variations within it) continues to apply.
International Value with Distillate Capital’s Thomas Cole
ValueWalk's Raul Panganiban interviews Thomas Cole, CFA, CEO and Co-founder of Distillate Capital. In today’s episode we discuss value investing in the current environment and why you should look internationally. Q3 2020 hedge fund letters, conferences and more International Value with Thomas Cole, CFA, CEO and Co-founder of Distillate Capital
This tells us something important about stock investing. A random walk pattern would tell us that Buy-and-Hold is the ideal strategy. If prices played out in the form of a random walk, it would be fair to say that the risk of a big price drop is the same at all times; so it would not be possible to predict future returns and the best practice would be to stick with the same stock allocation at all times. But, if prices play out in the form of a hill-and-valley pattern, the knowledgeable investor can predict his long-term return by noting in which direction (hill or valley) prices are headed. And if prices can be predicted, risk is not static but variable. If risk is variable, investors who wish to keep their risk profile roughly constant over time must be willing to engage in market timing to have any hope of doing so.
But investors should not be thinking solely of the long-term any more than they should be thinking solely of the short term. Returns are not predictable over time-periods of one or two or three years. But the returns obtained over those time-periods obviously matter. Smart investors lowered their stock allocations in 1996, when the CAPE value hit 25. And they did not fret too much when the market delivered 126 percentage points of return over the next four years; they knew that 100 percentage points of those 126 percentage points of return were the product of irrational exuberance and were temporary in nature. But there is a time-value to money. Even gains that are fated to disappear produce compounding returns for the time that they are reflected in the investor’s portfolio. It is one thing to not fret excessively about “missing out” on artificial, emotional-produced gains. It is something else again to say that those gains have no value whatsoever.
The Valuation-Informed Indexer should be focused on the long-term gains that his investment is likely to produce. It is the long term that matters most. But he should also be aware of the possible short-term and medium-term possibilities.
A good example of how the possibilities for the different time-periods can mix together was the situation that applied at the low point of the price crash of late 2008/early 2009. We saw a CAPE value of 13 in February 2009. It’s not true that stocks represented a huge bargain at that time, as some advisors claimed. But it is certainly true that they offered a very strong long-term value proposition. I recorded numerous podcasts during these months and I opened each one by noting that stocks offered a good deal at the prevailing prices.
Robert Shiller offered a somewhat different take. He suggested that it might be best for investors to stay out of stocks until the CAPE value dropped below 10. I understood why he said that. The normal scenario for a price crash that takes place following a long bull market is for it to continue until the CAPE value hits 8. So Shiller was describing the high-percentage bet. Prices were likely to continue dropping. An investor who wanted to make the perfect play should indeed have waited until the CAPE value dropped below 10 before reinvesting in stocks with the anticipation that prices would be heading upward for a long time starting from that price level.
I thought that the odds favored Shiller’s strategy. But I did not tell investors to wait until the CAPE level hit 10 before buying. I felt that the better strategy was to own a small percentage of stocks (perhaps 30 percent) even when prices were in the 20s and then to increase one’s stock allocation when prices fell below 18 (perhaps to 60 percent) and then to increase it again if prices fell below 12. The CAPE value will usually fall below 10 at the end of a bull/bear cycle. But this cannot be said with certainty and the penalty for failing to increase one’s stock allocation when prices are low is greater than the reward for picking the precise low point of the cycle to buy stocks.
Market timing is not a guessing game. It is a risk-management game. No one can guess where prices will be in the next year or two or three. So no one should try to do that. But investors who study the historical return data can know with near certainty that stocks become more risky as prices increase and less risky as prices decrease and they should not hesitate to adjust their stock allocation in response.
I believe that the failure to make this distinction between guessing and risk management is the cause of much of the hostility that Buy-and-Holders feel toward market timing. The Buy-and-Holders are right that it is impossible to pick highs and lows on a consistent basis. If that is what market timing is about, then it is a dangerous practice.
What they miss is that market timing done right is an exercise in risk management that pays big rewards in the long term. So long as market timing is practiced for that purpose, it is hard to see how it can go wrong. The market timer who is focused on risk management may or may not see higher nominal returns than his Buy-and-Hold friend. But he will almost certainly see higher risk-adjusted returns. That’s what intelligent investors should be seeking to achieve.
Rob’s bio is here.