Home Stocks The Important Story Is Why Some Forms of Market Timing Don’t Work

The Important Story Is Why Some Forms of Market Timing Don’t Work

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I am a big believer in market timing. I believe that the experts in this field made a tragic mistake when they concluded in the 1960s that market timing does not work. The reality (according to all of the evidence that I have come across) is that market timing always works and is always required. Market timing is price discipline. Price discipline is critical for the smooth functioning of all markets. So to discourage market timing in the stock market is a terrible mistake.

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I am always trying to come to a better understanding of why thinking about this subject has become so confused. People practice price discipline in all other markets without giving any thought to the possibility that that might be a bad idea. How did the idea that practicing price discipline when buying stocks might not work ever catch on?

Market Timing Often Does Not Work

The idea caught on because market timing/price discipline often does not work for a good bit of time in the stock market. Stocks were priced very high in 1996. The rational expectation would have been that prices would be coming down hard in not too long a time. But prices are even higher today. I still believe that prices will eventually be returning to fair-value levels and perhaps a good bit lower (irrational exuberance has always been transformed into irrational depression at the end of earlier bull markets). But it is beyond dispute that they have remained high for a very long time. Buy-and-Holders conclude from this that timing doesn’t work.

That’s not a fair conclusion. A fair conclusion would be that investors can never know in advance precisely when high stock prices will collapse. Engaging in market timing with the expectation of seeing good results from doing so is foolhardy. But evidence that short-term timing does not work is not evidence that long-term timing doesn’t work or isn’t required. To understand what is going on in the stock market, one must distinguish between the two forms of market timing.

The Buy-and-Holders completely misunderstand the reason why short-term timing doesn’t work. Their thought is that it is because investors are rational. Rational investors would take advantage of profit opportunities opened up by mispricings. So the logic here is strong. Rational investors really would make for an efficient market and market timing would never work in an efficient market.

However, the premise on which the Buy-and-Hold case is constructed is in error. Shiller showed that there is a strong correlation between today’s CAPE level and the stock return that will apply over the next 10 years. Stock prices would play out in the pattern of a random walk in a world in which the market is efficient. Long-term stock prices have been playing out in a hill-and-valley pattern for 150 years, as far back as we have good records. So the efficient market concept just doesn’t hold water.

Investors Are Highly Emotional

The mistake that the Buy-and-Holders made was in thinking that it is because investors are rational that short-term term timing doesn’t work. The reality is just the opposite! The evidence is that investors are highly emotional. Short-term timing doesn’t work because there is no way to predict highly emotional behavior. Stock prices should drop hard once they rise too high; that makes sense. But what makes sense matters little to highly emotional investors. So high stock prices often lead to even higher stock prices. Timing efforts rooted in a belief that investors will do the logical thing are doomed.

In the short term.

That is not true in the long term! The market cannot remain highly irrational indefinitely. If it did, it could not continue to function; the core function of any market is to get prices right. So sooner or later prices really do return to fair-value levels. We cannot say when prices are high that they will soon be dropping. But we can say that they will eventually be dropping. Which of course means that the investor who buys stocks when prices are high is taking on more risk than the investor who buys stocks when prices are reasonable. The investor who wants to keep his risk level constant needs to practice market timing (the long-term variety!) to have any hope of pulling that off.

The Buy-and-Holders were right to notice that short-term timing does not work. But they failed to grasp the reason why this is so. They concluded that it is because investors are highly rational when the reality is that short-term timing does not work because investors are highly irrational. That’s why long-term timing always works and should always be encouraged. Irrational investors send stock prices to crazy places and the only way to restore sanity to the market is with a price crash. Smart investors need to take that reality into consideration when setting their stock allocation. It is WHY short-term timing doesn’t work that is the important story.

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