Market Timing: Maybe the Greatest Risk is in NOT Timing the Market

Maybe the Greatest Risk is in NOT Timing the Market

Mark Vakkur, MD

[originally written January, 2001]

Introduction

It would be hard to read a popular financial magazine or newspaper without running into some variation of the following: "You can't time the market." What is usually meant by this is that you should invest in stocks for the long haul, ignoring market conditions. This idea has become so deeply ingrained that it has made many investors believe that they must blind themselves to the value of what they are buying.

Very intelligent, thoughtful people who would never buy a car or a refrigerator without comparison shopping have been told such effort is a waste of time when it comes to investing. Investors might spend hours stalking the best fund or stock but spend very little time asking the bigger question: how much (if any) of my money should be in the stock market today?

Why Bother?

Investors have been told to expect to make about 12% a year on average per year in the stock market. However, this rule of thumb, like so many others, has several flaws.

- First, it assumes that the post-World War II stock market, which by any measure was grossly undervalued at the beginning of the period and by any measure is grossly overvalued at the end of the period, is indicative of what we can expect in the future.

- Second, the average total return figures mask a lot of volatility. In 1973-1974, you would have lost 70-80% peak-to-trough after inflation in many growth mutual funds. Could you stomach this? Most can't; the majority of investors sell close to the bottom (if you think about it, that's what makes it a bottom, when everyone has thrown in the towel). Therefore, the average total return experienced by most investors is far below that "advertised" by the mutual fund and brokerage industry.

- Wild swings to the upside are dangerous also; in 1997, the S&P500 climbed over 30%, encouraging many investors to pile even more money into the market, which drove it even higher, prompting more buying, etc. Investors who put a significant percentage of assets into the market after 1997 significantly raised their average cost basis and are therefore unlikely to achieve the "lump sum" return of 12% per annum of someone who did not react to the market's movement at all.

- The assumption in these returns is that one achieves the returns of a broad market index, such as the S&P500. However, most investors still choose actively managed mutual funds, 70-80% of whom consistently underperform the index, or individual stock selection themselves. Some will outperform the indexes handsomely, but studies of individual brokerage accounts indicate that most don't.

Bottom line: those cheerful mountain charts showing how many millions a $10,000 lump sum investment made in the market in 1926 would have compounded to by today do not represent the investment experience of the vast majority of investors.

Where Do We Go From Here?

So why not ask the question, How Much Can I Expect to Make in Stocks in the Future Given Their Current Valuation?

In the end only two things drive aggregate stock prices:

· growth in corporate earnings and/or

· growth in the amount of money that an investor is willing to pay for a dollar of those earnings (an expansion of the price-earnings ratio).

(I have excluded dividends, since they must be paid out of earnings.)

When you buy a company, you are buying a claim on a stream of future earnings.

Unfortunately, history shows that investors tend to wildly overvalue and undervalue that future stream of earnings, meaning they project several quarters of strong growth into the stratosphere, driving up PE ratios to unsustainable levels.

Consider this: from January, 1945, to the present:

· Whenever the earnings yield (1 / the price-earnings ratio) on the S&P500 fell below 4.5%, the subsequent 10 year geometric average annual return of the S&P500 was only 4.3% a year (and would most likely have been significantly less if not for the most recent years of aberrant price performance in the face of earnings yields in the top 5% of all periods following World War II. As the earnings yield drops (the PE ratio rises), the next 10 years average rate of return drops. In fact, it is only when the earnings yield has been in the 5.8-7.7% range or above that the market has returned close to its "advertised" 10% historical return. To assume that one can expect an average 10-12% rate of return (nominal; about 7% real (adjusted for about 3% average inflation)) per year in the stock over the long haul simply is not supported by historical evidence. Yet millions of investors, lulled into believing this, plow money into the market and plan as though this assumption were true. One's rate of return is entirely dependent on the level of prices relative to earnings at the time the money was invested and is NOT simply a function of being invested for long enough. In other words, most investors (hopefully) understand that if they invest at a relative market peak in valuation that they may suffer a "paper loss," perhaps a dramatic one, at some point in the future, but they reassure themselves that the market will bounce back and if there holding period is long enough, that they will eventually enjoy the 10%-12% average annual return stocks have delivered before inflation. This is simply not true. The average rate of return each invested dollar will enjoy is a function not so much of how long it is invested in the market (although the longer the holding period, the more likely it is to approximate the long-term average) but at what point value-wise the money was invested.

Earnings yield:	Subsequent 10 year geometric average annual rate of return of the S&P500:
<>	4.3%
4.5- 5.3%	2.3%
5.3- 5.8%	3.4%
5.8 - 7.7%	8.0%
7.7 - 10.1%	10.0%
10.1 - 13.8%	11.3%
> 13.8%	13.1%

For example, an earnings yield of 2.0% would result in a predicted subsequent 10 year average rate of return of the S&P500 of 1.7%.

Note that the market has only returned 10% or more a year when the E yield was 7.7% or greater, meaning a PE of 13.0. (Note also that this excludes dividends and inflation; throw in the dividend yield of the S&P500 (currently less than 2% a year) and you can expect to make less in the stock market as you would in a good money market account right now (Fidelity Cash Reserves was yielding 6.2% at last check)).

Whenever the market has been as richly valued as it has been recently (3/2000), subsequent 20 year real returns were horrible:

Market Peak:	Next 20 Year Average Annual Real Return, Including Dividends:
1901	-0.2%
1929	0.4%
1966	1.9%

Source: Irrational Exuberance, Robert J. Shiller

· If history is any guide, then we should achieve far less than the historical mean of 11-12% a year in the stock market.

Note that for most Americans, 20 years represents the bulk of their investing lifetime, and for someone having the misfortune to retire at the beginning of such a historical period, the results could be catastrophic.

What To Do

So how can you avoid behaving in a way that is hazardous to your wealth? The answer is that you can't guarantee that you won't, but you can do a rigorous self-assessment today.

You must insure that you are comfortable with the percentage of investable assets that you have allocated to stocks. Add up all of your accounts, retirement and taxable, into one big portfolio, then determine what percentage are in stocks, cash, and bonds. All equity funds, growth funds, index funds, etc., are dollars of stock market risk and should be counted as such. Now do a little math: imagine half of those dollars wiped out at least on paper. If you are comfortable with this, if you are absolutely sure you will not sell if this occurs, then maintain your current allocation. As the saying goes, "sell down to the sleeping point," the point at which you can sleep with your current risk exposure. Do this every 6 months or so and adjust.

This is based on a static asset allocation model - e.g., 70% stocks, 20% bonds, 10% cash (money market mutual funds or Treasury bills). This static asset allocation model is the cookie cutter approach assumed by most financial planners and brokerage houses.

However, I think there is a superior method. Unfortunately, it has been so discredited by the popular media that it has become almost a pejorative term: market timing. I prefer the term dynamic asset allocation, but the idea that you should plow your money into the market blind to the price you are paying for the market strikes me as foolish.

Give up on the idea of getting out at the very top or in at the very bottom. It cannot be done. But the good news is, to build and preserve wealth over time, it need not be done. If you can catch 75% of the major upward moves and not be fully exposed to the market during times of extreme risk, you will do very well over time.

Summary

It's not all-or-nothing. You don't have to decide to put all your money in cash or all in the stock market, but given the nosebleed valuations of the S&P500 and what we know about how the market performed over long holding periods after such periods of high valuation, having the bulk of your investable assets exposed to the risk of the stock market does not seem prudent. Sure, the market could surge to new highs (and no doubt at some point will) and have plenty of see-sawing action to keep the daytraders happy, but for the average investor, it's probably a good time to batten down the hatches, get your financial house in order, and lighten up your exposure to stocks.