There’s a lot of confusion among stock investors today on the subject of market timing. Most think that it doesn’t work. But the reality is that it is only one form of market timing that doesn’t work – short-term timing (guessing when stock prices will go down and then when they will go up again).
Long-term timing (changing your stock allocation in response to big price shifts for the purpose of keeping your risk profile constant over time) always works.
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Why? Long-term timing is a sure thing. It is the core purpose of any market to get prices right. So, when stock prices get wildly out of whack, we can say with near certainty that in time they will return to fair-value levels.
We cannot say when. So extreme allocation choices are not a good idea. But it is hard to imagine how a moderate approach to market timing would not produce good long-term results.
Embracing Long-Term Timing
Few stock investors have the patience required to embrace long-term timing. Shiller warned investors in 1996 that those who stuck with their high stock allocations would likely regret doing so within 10 years. In reality, it was not until 2008 that we saw a price crash.
And stock prices returned to high levels in not too long a time following the crash and have remained there through today. Most Buy-and-Holders who ignored Shiller’s warning do not regret doing so 26 years later.
Those investors would pay attention if you could offer them an approach to market timing that always produced good results within five years. A big plus for such a strategy is that those making the case for it would not need to look to the entire historical record to do so.
There have been five five-year time-periods since Shiller made his prediction. If it could be shown that an approach to market timing worked in all of those time-periods, that showing would persuade a lot of people.
It can’t be done. Why is that? Why is it that a solid case can be made for long-term timing but not for short-term timing?
The problem is that the thing that makes timing work is the need for the market to recover from time-periods of extreme investor emotionalism. It is as if there were a magnetic pull to the fair-value CAPE level of 17.
When prices move far above that, there is a strong pull downward. And, when prices move too far below that, there is a strong pull upward. It is that strong pull that ensures that market timing will always pay off in the long run.
But the magnetic pull toward fair-value prices is not the only pull on stock market prices. The very thing that should make investors want to lower their stock allocations – crazy high prices – makes them want to ignore prices altogether, to adopt price indifferent (Buy-and-Hold) strategies.
Prices were at insanely high levels in 1996, when Shiller issued his warning. But they increased dramatically in 1997 and in 1998 and in 1999. The Get Rich Quick urge that resides within all of us exerts a pull on stock prices that for a time can be stronger than the pull in the direction of the fair-value CAPE level.
Making Work Of Short-Term Timing
Prices finally come down when the magnetic pull toward the fair-value price level becomes strong enough to overcome the strength of the collective Get Rich Quick urge.
For a short-term timing strategy to work, someone would have to develop a means of predicting when that turning point would be achieved. It cannot be done today. We do not know enough about human psychology to identify the turning point in advance.
Human psychology is complicated. Consider what happened in the wake of the 2008 price crash. Many Buy-and-Holders were wavering in their confidence in their strategy. The stalwarts said not to worry, that those who stayed the course would be rewarded for their diehard attitude. And that’s what happened.
Many investors will remember that when the next price crash arrives. Their unwillingness to sell will at least for a time limit the extent of the crash. In the long run, it may cause a more drawn-out price collapse because it will take longer for the various emotional cross currents affecting prices to resolve.
But who can understand the effects of the various cross currents well enough to identify turning points for stock prices with enough confidence to profit from the exercise?
If we had 10,000 years of return data for a relatively stable market, we might be able to do it. We would have enough experience with a sufficient variety of market conditions that we would be able to assign rough probabilities to different sorts of market conditions.
But we don’t have anything close to that amount of data. We have good records for 150 years of U.S. stock market history. Since the typical bull/bear cycle takes 40 years to play out, we have data for only four complete cycles.
We know a lot. We know enough to say with certainty (in my assessment) that market timing is required for those who want to keep their risk profile constant over time. But we do not know enough to make effective short-term timing recommendations.
Will we ever know enough? Perhaps. If that day ever arrived, we could eliminate stock investing risk altogether. I don’t believe that that day will ever arrive. But of course the Buy-and-Holders, who are almost invariably very smart people, sincerely believed that even long-term market timing would never be possible. So you never can say for sure.
Rob’s bio is here.