Are Stocks Expensive? The 2 Perspectives. (Part 2)

Let’s also talk about market timing.

Samuel Lee 31.07.2014
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A version of this article was published in the April 2014 issue of Morningstar ETFInvestor.

In part 1 of this article, we discussed the business-cycle perspective and the intrinsic-value perspective to value the market. In this part, we will discuss on market timing.

Conventional wisdom holds that market-timing is impossible. However, well-done studies find evidence that some hedge funds and to a much lesser extent some mutual funds have market-timing skill. I'm not talking about being able to predict one-month market returns--studies have almost universally failed to find compelling evidence of that. Rather, certain managers seem to be able to know when the liquidity or volatility outlook is benign or hostile and shift their market exposures accordingly. 1, 2 Manager David Tepper used P/FE to call stock markets extremely cheap in late 2012. He went as far as to say downside risk was low and the upside was high in part due to a global central bank put and muted inflation. He was right then, as he has been several times in the past, such as when he shifted to 40% cash in late 2007 and shifted back into risky assets in early 2009. The myopic earnings model plus a keen understanding of central-bank posture seems to be a potent combination for timing the market.

We do not see very many intrinsic-value investors timing the market. Why? Because intrinsic value is near-worthless for predicting market movements over horizons shorter than a decade. It is surprisingly hard to come up with a robust valuation-based market-timing rule that generates abnormal returns even in a back-test. (On the flip side, it is very easy to find momentum-based timing signals that work in back-tests.) Anyone who makes a habit of leaping in and out of the market based on valuation is going lag the benchmarks for long periods, even if such efforts prove profitable in the end. The most successful intrinsic-value investors are stock-pickers who don't time the market, doing so perhaps once in a generation when valuations become so extreme they must revert within a reasonable window. I believe most successful market-timers play the Keynesian beauty contest. They cannot abide the notion of an idealized fair value toward which the market must gravitate.

Successful market-timers share some similarities:

1) They do not work for Wall Street banks or brokerages or make punditry their calling--they are hedge fund managers (and, rarely, mutual fund managers).
2) They believe central banks have enormous influence over asset prices and therefore never try to fight them without strong reasons.
3) They tend to chase momentum, or at least give it wide berth, all the while knowing that when market expectations are at such odds with near-term fundamentals, they should bet against the trend.

The last part distinguishes the George Soroses of the world from the wannabes.

So, what does this mean in terms of practical investing advice? Defenestrate buy-and-hold and take up macroeconomic forecasting? Hardly. Being a Michael Jordan is possible, but it ain't you. Market-timing can be profitable, but there are only so many market cycles in an investor's lifetime. Even if you successfully time the market on occasion, it's difficult to know whether it's due to luck or skill. Predicting where the market is heading is an exercise in supreme (almost certainly unjustified) self-confidence.

Most investors should not time the market but rather behave more like intrinsic-value stock-pickers: Hold on to equities like grim death, making adjustments over time against the market's gyrations. They should ignore all the forecasts generated by the Wall Street noise machine, because such forecasts are procyclical and usually wrong over the long run. Moreover, those forecasts are designed for people who must run the myopic earnings surprise race. Individual investors saving for retirement have the luxury of taking the long view--if they can discipline themselves to not be envious of their neighbors.

Besides, for someone playing the short-term pricing game, taking Wall Street's forecasts seriously puts him behind the curve. After all, the Keynesian beauty contest is about being a superior judge of the consensus' view of the consensus, not simply being part of it. The main reason to consume public research from Wall Street is to identify consensus positions and see where they diverge most from one's private assessments.

Because the costs of market-timing are enormous and potentially fatal to one's retirement plans, investors who have substantial assets to lose should not play the game. Young investors with a long runway of lifetime earnings ahead of them can afford to play the game and learn over time whether they're any good at it without killing their retirements. They should, however, understand that they're likely to be on the losing end and therefore size their positions appropriately.


1 Charles Cao, Timothy T. Simin, and Ying Wang. "Do Mutual Fund Managers Time Market Liquidity?" Journal of Financial Markets, 2013, Vol. 16(2), 279–307.

2 Charles Cao, Yong Chen, Bing Liang, and Andrew W. Lo. "Can Hedge Funds Time Market Liquidity?" Journal of Financial Economics, 2013, Vol. 109, 493–516.

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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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