Market timing is fraught with problems. Specifically, it doesn’t work.
Ben Graham addressed the risk of adding a timing component to your strategy in Security Analysis. He points out two important problems that lead to poor timing in a bull market.
One is a problem that comes with selling. The other is failing to know when not to buy.
Here’s what he had to say:
The old rule for the ordinary investor was that he should buy sound securities when he had funds available. If he waited for lower prices he would be losing interest on his money; he might “miss his market,” even if prices declined; in any case, he was turning himself into a stock trader or speculator. Much of this view retains its validity. However, the time when the investor should clearly not buy common stocks is during the upper ranges of a bull market. For most issues this is tantamount to saying that he should not buy them at prices higher than can be justified by conservative analysis — which is something of a truism. But, as we pointed out previously, this warning applies also to the purchase of apparent “bargain issues” when the general price level seems dangerously high.
There remain two other major questions of investment timing. The first is whether the investor should try to anticipate the movements of the market — endeavoring to buy just before an advance begins or in its early stages, and to sell at corresponding times prior to a decline. We state dogmatically at this point that it is impossible for all investors to follow timing of this sort, and that there is no reason for any typical investor to believe that he can get more dependable guidance here than the countless speculators who are chasing the same will-o’-the-wisp. Furthermore, the major consideration for the investor is not when he buys or sells, but at what prices.
This is an aspect of the “timing” philosophy that has been almost completely overlooked. The speculator will always be concerned about timing because he wants to make his profit in a hurry. But waiting for a profit is no drawback to an investor, as compared with having his money uninvested until a propitious buying “signal” is given, unless he thereby succeeds in buying at a sufficiently lower price to offset his loss of dividends. This means that timing, as such, does not benefit the investor unless it coincides with pricing. Specifically, if his aim is to buy and sell repeatedly, then his timing policy must enable him to repurchase his shares at substantially under his previous selling price…
A more serious question of timing policy, in our opinion, is presented by the well-defined cyclical movements of the stock market. Should the investor endeavor to confine his buying to the lower reaches of the recurrent bear markets, and correspondingly plan to sell out in the upper ranges of the recurrent bull markets? In such a policy, timing and pricing would clearly coincide — he would be buying at the right time because he would be buying at the right price, and vice versa.
No one can tell in advance how such an investment philosophy will work out in the years to come. Presumably its theoretical justification must be sought in the market’s past history. If this is studied with some care, the indications it yields will not be found too encouraging.
Graham’s first mistake of timing is more of a warning: Beware of buying “bargains” in a bull market. Confusing a business that happens to be doing well with a great business is costly.
A great business tends to perform more consistently over the entire business cycle. Overpaying for a great company isn’t the best option, but can still work out okay in the long run.
A business that happens to be doing well is not a top-tier company. They often look like a “bargain” because recent earning have improved but they lack consistency in performance over the entire business cycle. Cyclical companies come to mind. Their earnings are dependent on growth in the economy. So their earnings, and stocks, tend to rise and fall with the business cycle.
Cyclicals are notorious for looking like bargains at the peak of the cycle. Investors who use the improved earnings to forecast future earnings to value the company quickly learn that the stock price is also at its peak. Put simply, the company looks cheap based on recent earnings but is really expensive based on future earnings. Once the business cycle turns, earnings follow, and the stock tumbles.
Of course, cyclicals aren’t the only companies investors mistake for “bargains” in a bull market. Sometimes those “bargains” look cheap compared to everything else. Relative valuation is a quick and dirty way to compare a company against its peers to see if the market fairly values it or not. And the market is often ruled by relative valuation in the short term. The downside: it can easily be misused.
I’ve seen relative valuation used numerous times in recent months. Company X is undervalued, the argument goes, because Company Y and Z trade at much higher multiples. The most suspect arguments rely on a single multiple, like Price/Sales (trading at double digits, of course), to justify undervaluation.
But the real mistake is failing to consider that Company Y and Z are overpriced. Maybe they’re not but it needs to be addressed. The automatic assumption that the “bargain” will rise to the level of its peers, instead of the peers falling, is a symptom of an overly-optimist market. It’s also a great way to lose money.
As for the general problem of market timing, Graham quickly puts that to rest. The only reason to time anything is for the opportunity of a much lower price. Selling any investment, with the theory of buying it back at a lower price is hardly guaranteed. The risk of selling is that you wait and wait and wait for a buying opportunity that never comes.
And past market cycles turn out to be poor predictors of future cycles too. So relying on that to dictate buying/selling creates a similar problem. Again, the risk is that you miss out on so much money being out of the market that it outweighs any benefit the timing might create.
Of course, all the above ignores the psychological toll of being out of the market and missing out on gains — something Graham was concerned about too. It also ignores the reason most people try to time the market. Hint: They’re rarely thinking about buying at lower prices. They really want emotional relief. The market is whipsawing around and they would rather be out of the market until things calm down. But the result is the same. Investors are likely to get better returns had they never sold.
Security Analysis, 3rd Edition
- Stalking Bubbles: Paul Tudor Jones, 1987-1990 – Neckar’s Notes
- Interest Rates, Earning Growth and Equity Value: Investment Implications – Musings on Markets
- How Well Do Consumers Forecast Inflation? – St. Louis Fed
- Party Like It’s 1999: From ETrade to eToro – Net Interest
- The Replication Crisis That Wasn’t – C. Asness
- Bill Gurley on Entrepreneurs and Technology (podcast) – Masters in Business
- The Revised Psychology of Human Misjudgment by Charlie Munger – Farnam Street
- Nature’s playbook: Nature Knows How to Avoid Network Collapse – Aeon
- Why Is Tower Records Coming Back Now, of All Times? – Slate