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If Market Timing Works. Then It Is Absolutely Critical

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Robert Shiller has described the intellectual leap from the finding that short-term price changes are unpredictable (University of Chicago Economics Professor Eugene Fama showed this in research published in the 1960s) to the Buy-and-Hold belief that the market sets prices properly as “one of the most remarkable errors in the history of economics.”

I think that’s right. I don’t think that even those who agree with Shiller and me on this point (most stock investors do not agree) fully appreciate how much harm was done by this mistake and how much good would be done by correction of it.

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Short-Term Market Timing

The old way of thinking about market timing is that it is a parlor trick. Guess the days when market prices will go up or down and you can add a few extra dollars to your portfolio. Maybe you can pull it off and maybe you can’t. Either way it’s not a big deal.

In reality, it’s a super big deal.

To understand why, it helps to think about why this remarkable error was made. As Shiller indicates, Fama showed that short-term price changes are unpredictable. That can fairly be read as a finding that short-term market timing does not work.

If investors cannot know in advance when price changes will take place, they cannot engage in effective market timing. Fama’s finding has stood the test of time. Short-term market timing really does appear to be a bad idea.

The error was in thinking it follows that the market sets prices properly, that the market is “efficient.” As Shiller suggests, that doesn’t follow at all. An efficient market is a market in which investors act rationally. It’s entirely possible that short-term price changes could be unpredictable in a world in which stock investors acted irrationally.

That actually seems like the more plausible explanation of Fama’s finding. In a world in which investors set stock prices at all sorts of crazy places, there is nothing for market timers to look at to determine where prices are headed; they could be headed anywhere.

For stock investors to engage in effective market timing, they need to know something that the market doesn’t know. They need to beat the market to the pass, so to speak. Identifying that something explains why one form of market timing really doesn’t work while the other form (long-term market timing) always does.

Shiller’s finding that valuations affect long-term returns can fairly be read as a finding that long-term market timing always works. Knowing the valuation level, an investor knows where stock prices are headed. He doesn’t know when they will change, so he cannot engage in short-term timing effectively, but he knows in which direction they are eventually headed, which is all he needs to know to succeed at long-term timing.

Short-term timing doesn’t fail because investors are rational. It fails because they irrationally set prices at all sorts of crazy places that cannot be predicted. Long-term timing succeeds because there is an element of rationality in the market that no amount of investor emotion can take away.

No matter how high or low stock prices go in the short term, they must eventually reflect the economic reality. And in a stable economy like the U.S. economy, the annual stock gain that reflects the economic realities is 6.5 percent real. That translates into a CAPE value of 17. These numbers can be known to any investor who cares to know them.

A Tug Of War

It’s rational for stock prices to reflect the economic realities. So in one sense the market really is efficient. However, there can be long periods of times when the CAPE value is far above or far below 17. The market is always moving in the direction of efficiency.

But the emotional investors are often pulling hard in the direction of inefficiency/irrationality. Today’s stock price is the product of a tug of war between the part of our brain that wants stock to be properly priced and the part that wants something for nothing.

This analysis suggests that market timing is far more than a parlor trick. It is not about making a few extra bucks. Understood properly, market timing is the means by which we can make the market functional. The market needs to be pulled in the right direction to get prices right. If investors became educated as to the how-to implications of Shiller’s research, we could all participate in getting the job done.

Stocks are less appealing when prices are high. So educated investors would react to high stock prices by lowering their stock allocation. The result of the reduced demand for stocks would be more reasonable prices. Stock prices are self-regulating so long as stock investors act in their self-interest.

Which they would if only the Buy-and-Holders had not made the “remarkable error” that causes them to discourage market timing! Market timing is not some silly means of making a few extra bucks. It is the means by which stock investors work to keep market prices at reasonable prices, which benefits all of us.

A stock market in which the CAPE level always remains in the vicinity of 17 is a stock market of little volatility. A stock market of little volatility is a stock market of greatly diminished risk. But one still providing great returns. Investor heaven!

Remarkable error indeed! It’s not just that long-term market timing always works. It’s that it is absolutely imperative for all investors. All who participate in the market should be doing their part to keep prices right. All stock investors should engage in market timing regularly.

Rob’s bio is here.