The Day On Which Shiller Suggested That Market Timing Might Not Always Work

Published on

I believe in market timing. I don’t just believe that it is something that might work now and again. I believe that it is absolutely essential at all times. Market timing is price discipline. It is the means by which the market gets prices right. If the market prices stocks too high, the value proposition offered by stocks is diminished. So informed investors lower their stock allocation, pulling stock prices down to where they should be. That’s market timing! If enough investors fail to do that (Buy-and-Holders discourage them from doing it), prices get so high that the only way the market can get them right is to crash them and that puts us all in the soup.

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Q2 2022 hedge fund letters, conferences and more


Valuations Affect Long-Term Returns

My strong belief in market timing is rooted in my confidence that Robert Shiller’s Nobel-prize-winning research showing that valuations affect long-term returns is legitimate research. If valuations affect long-term returns, the value proposition of stocks is not stable but variable. Stocks offer a better deal when valuations are low than they do when valuations are high. So investors seeking to keep their risk profile constant over time MUST engage in market timing. There’s no other way to do it. If an investor’s proper stock allocation at a time when stocks were priced at fair-value levels is 60 percent, his proper stock allocation cannot possibly be 60 percent when stocks are priced at two times their fair value.

Here are some words that Shiller once advanced in an interview that might cause some to believe that he does not believe that:

“John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price-earnings ratio. And that had a pretty good fit. So I think that we were giving – and maybe we didn;t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism. It doesn’t tell you – and I had the same mistake in mind, to some extent – wait until it goes all the way down to a P/E of 7 or something.”

“It’s not a timing mechanism.” That’s a direct quote from the master. He’s saying that timing doesn’t work, is he not?

Short-Term Market Timing Doesn't Work

He is saying that one form of timing doesn’t work, that’s for sure. He is saying that short-term timing – trying to guess when prices will turn downward (when you will lower your stock allocation) and then when they will turn upward again(when you will increase it to a higher level again) doesn’t work. I certainly agree with that. I am every bit as much opposed to short-term market timing as are my Buy-and-Hold friends. And I agree with Shiller’s suggestion here that it is not a good idea to conclude that, because the CAPE level has dropped to 8 in earlier price crashes, it makes sense to wait until it hits 8 to begin buying stocks again in the days following the next one. Stock prices could turn upward again once the CAPE value hits 12. There are no hard-and-fast rules about this kind of stuff. We do not have enough data in the historical record to know that we have seen all of the possible return patterns play out in an earlier time.

But showing that one form of timing doesn’t work is not at all the same thing as saying that no form of timing works or even that some form of timing is not always required. Drunk driving doesn’t work. Accepting that reality is not the same thing as concluding that it is never a good idea to get behind the wheel of a car. We need to distinguish drunk driving from sober driving by understanding why one doesn’t work and the other does. Similarly, we need to distinguish short-term timing from long-term timing by understanding why one doesn’t work and the other does.

Short-term timing doesn’t work because it is a guessing game. It is shifts in investor emotions that cause stock price changes. Investor emotions are unpredictable. So this form of timing relies on luck to succeed.

The situation is very different with long-term timing. All that is required for long-term timing to work is that stocks continue to perform in the future at least somewhat as they always have in the past. In the past, stock prices have in the long run always moved in the direction of the fair-value price. That’s because the core purpose of all markets is to get prices right. Long-term market timing is a risk management practice. It works on the day that the investor makes the allocation change because it is on that day that he gets his risk profile back to where he wanted it to be all along. No one can say when he will move ahead of his Buy-and-Hold friends in terms of the number of dollars in his portfolio. But the investor who keeps his risk profile constant over time obviously has the long-term edge.

I wish that Shiller had explained all that when he made the statement quoted above. It is confusing when the researcher who showed why market timing is so essential says the words “it’s not a timing mechanism.” The caveats that he offered are valid and important. I am glad that he made clear that there are approaches to timing that are not likely to work. But I wish that he would be more direct in his advocacy of the long-term market timing concept. We are at dangerous price levels today and we would not be if all investors were being sure to practice market timing as needed and if all investment advisers were being sure to remind them to do so.

Rob’s bio is here.