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The bias against market timing

Many investors are sceptical about timing the market, even though there's lots of evidence we can do so. There are good reasons for such scepticism – but also bad ones.
The bias against market timing
  • We can use several lead indicators to predict aggregate equity returns, such as the dividend yield and price-money ratio.
  • Even so, many investors distrust market timing - some of them for good reasons. 

“You can’t time the market” is one of the oldest cliches in investing.

Which is unfortunate, because it isn’t true. My chart shows one reason why. It’s that the dividend yield has been a fantastic predictor of medium-term returns on the All-Share index. High yields in 1992, 2003 and 2009 all led to big rises, whilst low yields in 1987, 1998 and 2007 all led to falling prices. In fact, the yield alone can explain 60 per cent of the variation in five-yearly returns on the index since 1985.

It is not the only thing we can use to time the market. Meb Faber at Cambria Investment Management has shown that a simple rule of buying when prices are above their 10-month average and selling when they are below it would have increased investors’ risk-adjusted returns on the S&P 500: the same is true of the All-Share index and emerging markets. And we know that equity returns can also be partly predicted by the ratio of prices to the global money stock or UK retail sales; the yield curve; and even the time of year.

What’s more, theory tells us that it should be easier to time the market than to pick stocks. Nobel laureate Robert Shiller has shown that his fellow laureate Paul Samuelson was correct to say that stock markets are “micro efficient but macro inefficient”. Dividend yields, he shows, predict dividend growth rather than returns for individual stocks – as efficient market theory predicts – but they price changes for the aggregate market.

There’s a reason for this. If one stock is cheap relative to another, investors can short-sell the expensive stock and buy the cheap one and eliminate the mispricing to at least some degree. If the aggregate market is over-priced, however, there is much less that arbitrageurs can do because it is dangerous to go short without an offsetting long position. Which means the aggregate market will be occasionally mispriced.

Both evidence and theory therefore tell us that we can time the market. Of course, nobody pretends we can do so perfectly. We cannot sell exactly at the top and buy right at the bottom. But this fact no more discredits market timing than a few losses on individual stocks discredits stock-picking. What matters is whether we can increase risk-adjusted returns over time with market timing. And the facts suggest we can.

Which poses the question: why, then, do so many people believe otherwise?

There are good reasons. Short-term market timing is impossible. Whereas the dividend yield explains 60 per cent of the variance in five-yearly returns on the All-Share index it explains only 1.4 per cent of the variance in monthly returns. That’s not enough to base a strategy upon. In the short-term, cheap markets can get cheaper and expensive ones more expensive. It’s only in the longer-term than mispricings are corrected.

Also, some lead indicators of are unreliable, because statistical relationships can break down. For example, from the mid-1990s to 2019 big foreign buying of US equities was a great predictor of falls in global equities. But this has ceased to be the case: investors were big buyers in the year to July 2020, and yet markets have risen strongly since then.

Another legitimate reason to oppose market timing is that it can be expensive. Selling a portfolio of equities incurs dealing costs and perhaps tax liabilities.

But this need not be so. Within a unit-linked pension you can switch between funds at no cost. And if you have a core-satellite strategy with a big ETF you can cut your equity exposure at the cost of just one trade. 

Opponents of timing are also correct to say that futurology is futile: we cannot see recessions coming, let alone pandemics.

But we don’t need detailed stories about the future. In fact, they are a positive menace.

Nor should we trust our (or anybody else’s) judgment. All we need to know is that some lead indicators send useful messages. Think back to 2007. Very few people then foresaw the impending financial crisis. But we didn’t need to. All we needed to know was that the dividend yield was low; that foreign investors were big buyers of US equities; that the All-Share index was below its 10-month average; and that the US yield curve was inverted. All these were warnings to sell. And all were correct. You don’t need to know why the market will fall. You only need to know that it probably will.

I fear, though, that there is a less good reason for antipathy to market timing. For a long time we simply did not need it because from the mid-1970s to late 1990s the market trended up strongly; even after the 1987 crash the All-Share index in total return terms was back at its pre-crash high within two years. Our formative years, then, have led us to believe that time in the market matters more than timing the market, and that there can be a big cost to being wrongly out for the market even for only a short period.

That experience, however, might be a bad guide to the future. Equities did well in the late 20th century in part because of a massive relief rally. The things that scared investors such as inflation, high taxes, trades union power and serious depressions all receded as threats and so shares rose as a result. Such rises might not, though, be repeated – and in fact have not been in the UK so far this century. Instead, in a world of secular stagnation long-run average returns might be low, and bear markets thus more likely. If this is the case, then antipathy to market timing is now a legacy idea – something that was reasonable once but is no longer so. Perhaps, then, it is time to take it more seriously.