14 Dec 2018 How to Time the Market

Jesse Livermore was a stock trader who made his fortune during the 1929 stock market crash, in which he heavily shorted U.S. stocks and then began to buy them up near market lows. On the worst day of the crash, October 29, 1929, Livermore is said to have made the equivalent of $3 billion in one day of trading. Since then (since time immemorial, really), this notion of trading stocks based on the ever cyclical nature of the economy at large and the stock market in particular–commonly referred to as “timing the market”–has long since captured the imaginations–and fortunes!–of many an investor, both professional and amateur.

The idea is sound enough, intuitively. As this article in The Economist yesterday points out, there are ratios like the “Cyclically-Adjusted Price-Earnings” ratio (CAPE, for short) that measure the price of a broad index of stocks (like the S&P 500) relative to the underlying earnings of those stocks. The idea is that as that ratio gets above its historical averages (i.e., as the price of stocks bears an increasingly tenuous relationship to the reality of earnings), then the future performance of stocks should come down. And indeed that typically happens, eventually. But as the article points out, any strategy that attempts to “time the market” based on selling when the CAPE ratio gets above its historical average is a pretty terrible strategy, since stocks can bear a tenuous relationship to reality for far longer than we might like to think, and in the meantime those who have sold their stocks miss out on periods of high returns.

But what about if we apply a “catalyst” to the idea of timing the market based on valuations? There are several “factor tilts” that quantitative fund managers use in an effort to juice returns, and “Momentum” is one of the primary factors. The idea here is that you sort of combine the historical average of CAPE with a sense of which direction stocks have been trending, and that helps to keep you invested for longer periods of time (i.e. stay in the market when valuations are high because the momentum of stocks going up is still strong). But these strategies, besides being highly complex and difficult to research the efficacy of, are expensive and off limits for most investors.

So what gives? Is it possible to reliably time the market? Is there some way to read the tea leaves of the markets either through gut feeling like Livermore or through the perhaps dangerously-clear cut mathematics of the quants? I don’t know, to tell you the truth. For the Livermores of the world attempting to do this based on gut feeling or broad macro-economic trends, I have basically zero hope. Livermore himself is a warning to this, as he lost his entire fortune within a few years and would eventually commit suicide. For the quants of the world, I can’t rule out that at some point we may find a set of factors that over long periods of time outperform the market, but right now they are too expensive and exclusive, and even then such a strategy would come with a behavioral cost.

In our view, that leaves just one option, and The Economist piece I referenced above nails it: The only cost-effective, evidence-based, behaviorally aware method of timing the market is rebalancing. That’s it. Boring old rebalancing. See, an investment strategy based on a fluid financial plan includes not only an asset allocation–say 60% stocks and 40% bonds–but also a set of specific ranges outside of which a portfolio must be re-weighted to get back to that target of 60/40. Over time this keeps you from being over-exposed or under-exposed to risk, which has the effect of selling assets that are too expensive and buying the ones on sale.

Rebalancing is not magic. It’s not going to make you rich. It will, however, help keep you from going broke. Like the piece says:

The virtue of rebalancing is that it is simple. You are less likely to make a costly mistake than if you follow a more complex strategy. The drawback is that you must give up the delusion that you can time it like Livermore. To do what he did takes nerve and a rare feel for markets. You may think you have such talents. You almost certainly don’t.

So as this rocky quarter draws to a close, please take a look at your portfolios to make sure they are still in line with the targets you’ve set out as appropriate. This is something we always have an eye on for clients, but if you don’t have someone doing that for you, your 401(k)s and other accounts can easily get out of whack. Don’t put it off!