From Institutional Investor, Nov. 11, 2015:
Market timing — considered by many an investing sin — can be a virtue if employed modestly, using a combination of contrarian and trend-following strategies.
For 15 years we have attributed the following quote to late
economist Paul Samuelson, though, admittedly, we can’t
find a trace of it now. We remember him saying near the height
of the technology bubble of 1999–2000, when stock prices
were at astronomical highs, something along the lines of,
“Market timing is an investing sin, and for once I
recommend that you sin a little.” He meant — if he
ever actually said it — that things were so obviously
wrong at that time that even a lifelong proselytizer of
buy-and-hold would recommend some judicious selling. In
attempting to confirm this quote, one of us checked in with
Vanguard Group founder Jack Bogle, who could not help us with
attribution but admitted to lightening up on stocks himself
somewhere near the high. (We can confirm that he did indeed
make very prescient and public forecasts of lower than normal
expected long-term stock returns at the time.)
If market timing is a sin, then there are times when even
the saints can be tempted into sinning a little. We are going
to argue that market timing isn’t really a sin except, as
for so many things, if done to excess. But the results and
logic behind the two simple strategies that govern so much of
the investing world — basic value, or contrarian,
investing and basic momentum, or trend-following, investing
— imply that when it comes to market timing, one should
indeed sin a little and do so as a matter of course, not just
at extremes.
Today’s high stock prices, and for that matter low
bond yields and concomitant low expected future returns (at
least in our opinion), naturally bring the timing discussion
back to the forefront, leading many investors to wonder if they
should get out now. The answer to this question is almost
certainly not. “Getting out now” is a very extreme
action yet oddly often how people think about market timing (an
approach to timing that we will soon label binary, immodest and
asymmetric). If, on the other hand, investors wonder whether
they should own somewhat fewer stocks and bonds than usual
right now — well, that’s a much harder and much more
interesting question. Overall, for those who think market
timing is infeasible, we give hope. At the other extreme, some
observers oversell market timing as easy and reliable. It
ain’t.
Some of the strongest evidence seemingly in favor of
timing the market comes from studies of long-term
“predictability” of stock market returns using
valuation measures (like the dividend yield or price-earnings
ratio of the market). Perhaps the best-known approach uses
Yale University professor Robert Shiller’s version of
the P/E ratio for the entire S&P 500 (the cyclically
adjusted price-earnings ratio, or CAPE). We’ve been
using this method ourselves since the
technology bubble. This measure compares the current
market price with the average inflation-adjusted earnings per
share over the past decade (so as to smooth excessive
fluctuations in annual earnings). Currently, the ratio (about
25) shows that equities are very expensive compared with
historical levels but not very close to record highs (the
CAPE peaked in the 40s in early 2000). Expensive valuations
can be bearish timing signals if we expect valuations to
revert to their long-run averages. Furthermore, even without
this expectation, buying at a higher CAPE is similar to
simply buying at a lower yield where all-else-equal you make
less even in the steady state.
Let’s look historically at what happened to returns
over the next decade when starting from different Shiller
P/Es (from now on, when we say P/E or Shiller P/E, we always
mean Shiller’s CAPE). Incidentally, we focus on the CAPE
for exposition, but many measures of price divided by
fundamentals for the market give similar results to what we
find in this article. In Exhibit 1 we bucket each ten-year
period since 1900 by starting CAPE (looking at it every
month) and see what happened, on average, from there.
We see a clear and strong relationship. Decades that
started with low P/Es had, on average, subsequently higher
average excess (over cash) returns, and decades that started
with very high P/Es experienced the opposite: very low
average excess returns by historical standards. Of course,
like all averages, a lot of variation is obscured by only
looking at this summary. There was quite a range around the
average decadelong return in each of these buckets. Still, in
general, even with such a range, averages count a lot, and
other performance measures tell a similar story. For
instance, worst cases (if you actually picked the worst of
all possible decades among all those in the same bucket) get
steadily worse after buying at higher prices. Best cases,
while never very bad in any of these buckets, get steadily
less good after you buy at higher prices.
So we’re done, right? Market timing is easy! Simply
measure the CAPE and act as a contrarian, buying when the P/E
is low and selling when it’s high.
Not so fast....
...
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