Session 34 (of 42): Market Timing - Does it work?

0:00 Hi. Welcome back. When I started these sessions on market timing, I called them the impossible dream. Kind of gave away my biases there, arguing that it's really, really difficult to win at market timing. This session I want to focus on the odds of winning in market timing, why people continue to try it, and how it might work for some people in the market. The evidence in market timing, as I said, is everybody does it. If you're a mutual fund manager, the way you do it might be in how much cash you hold in your portfolio. If you're an investment newsletter, it might show up in the words you use to describe the market, the bullish or bearish views.

0:40 Market strategists who work at investment banks start up every year, give you their market timing views by telling you what they think the market will do over the next year relative to holding your money in cash or in bonds. Everybody does it. But do they do it well? Can it actually make money for them? Let's start with mutual fund managers. As I said, equity mutual fund managers are restricted in two ways. One is they can only be long, not they can't sell short, and second, they're restricted to holding their money in equities.

1:13 That already puts you in a straight jacket when it comes to market timing, right? So if you think stocks are overpriced, you have no place to go. It you can't shift your money out of stocks, and because you're supposed to be investing in equities, you really can't do much about your view on market timing. But mutual fund managers still find a way to time markets, and the way they do it is in how much cash they hold in their portfolio. So let's say you're a mutual equity mutual fund manager with a hundred million dollars that you're managing.

1:41 And you're bearish about markets. You think markets are overpriced. You might decide to hold more cash, 20 million out of the hundred million, 25 million. The percentage of your money that's invested in cash becomes an indirect proxy for what you think about markets. But does it actually predict markets? If you can observe what mutual fund managers hold in cash, is there any evidence that mutual fund managers are good market timers? In this graph, in the columns, you see the amount of cash that equity mutual fund managers hold. And across time, you can already see that cash as a percentage of assets has decreased pretty substantially from the 1980s and 90s down to today. Part of that might be a reflection of a bull market that's lasted a long time. But you look at the correlation between changes in cash holdings and stock returns, the correlation is close to zero.

2:35 There is zero information in what mutual fund managers seem to do with cash and what happens to markets in subsequent periods. In effect, if mutual fund managers are good market timers, it's sure not showing up in the cash holdings every year. There's a subset of mutual funds that actually pride themselves in the market timing. They're called tactical asset allocation funds. In theory, here's what they promise their clients. If you put your money with us, we will invest a lot in stocks when we think stocks are going up, but if we think a bear market is coming, a correction is coming, we'll pull your money out of stocks.

3:14 So in this graph, there's actually a comparison between what tactical asset allocation funds have earned versus a 60/40 portfolio. You're saying, "What's a 60/40 portfolio?" 60% of money goes in stocks, 40% in bonds. It's the actual opposite of market timing. It's a very widely used default proxy for what investors should do. You know what? In the four years here, out of the four four good years for markets, the 60/40 portfolio beat the tactical asset allocation funds. You're saying, "That's to be expected in good years."

3:48 No, but just putting your money in stocks works. But let's take the bad year, because remember the promise of tactical asset allocation is they're going to save you money in the bad years. Turns out they didn't save you much. There have been much more extended studies of tactical asset allocation funds or mutual funds that try to time markets. The evidence is in the long term, there is zero evidence that these tactical asset allocation funds generate enough returns for their investors to cover the fact that they're out of markets for extended periods.

4:21 Let's move on to hedge funds. The view in markets is that hedge fund managers are smarter than the rest of us. And there's a subset of hedge funds, not all of them, a subset, that try to time markets, that do asset allocation based on markets. And the studies that have looked at hedge funds find some evidence, though it's not overwhelming, that this market timing generates higher returns. Let's be very clear, though. The returns we're talking about is not double the returns of an average investor. You add a couple of percent.

4:51 Now, that also requires these hedge funds to not just trade a lot, but in order to to trade frequently, but have higher transactions costs. And we factor in that as a client in these hedge funds, you got to pay them two and 20, and we talked about this earlier. I'm not sure it covers the payoff to market timing. Now, so when you look at hedge funds, and that's that are much better timing markets, their success seems to come from the fact that they adjust their holdings of equities ahead of major liquidity changes. When markets are going to get more illiquid, they manage to get out a little faster than everybody else. It'd be interesting to see updates of these studies to see if it's held up as the hedge fund business has become bigger and has more capital. But at least the early studies seem to indicate some evidence of market timing.

5:41 What about investment newsletters? Here again, there's a glimmer of hope. There are some, you know, investment newsletters that claim to forecast what the market will do. And there is some evidence that it works, but the returns earned is, you know, compared to a buy and hold strategy, a lot of those newsletters fail. 180 out of the 237 newsletters that were examined in early study delivered lower returns than buy and hold. And the weights they they delivered, you know, for those in those cases were about the same before market upturns and downturns. So, in fact, they suggested that your equity weight be 58% before a market upturn, but it wasn't that much different before a market downturn.

6:26 So, they're market timers are sure are hiding it in the recommendations they pass out. And one of the scarier thing about investment newsletters is the bad market timers stay bad. And often people continue to subscribe to those newsletters. Maybe they share the same conspiracy theories about or views about why markets are low. But bad investment bad market timing investment newsletters continue to stay bad and continue to hold on to their readers. As I said, there's some a glimmer of hope that some of these newsletters do deliver good advice. Some of it might be, if you cover enough investment newsletters, there are 500 or 1,000 investment newsletters, purely by luck a few are going to beat the market. But there is mild evidence of market timing.

7:13 And, you know, if you look across both short but the catch is it requires frequent and short-term trading. So, basically, you make 1 or 2% more than somebody who just holds a buy and hold strategy or a 60/40. But if you have to trade 100 times a year or 200 times a year, your transactions cost are going to wipe out those excess returns. So, here's the bottom line. Mutual funds, no evidence of market timing. Hedge funds, some evidence of market timing, but if you factor in the costs you face as a client in these hedge funds, those excess returns disappear.

7:51 Investment newsletters, a few of them seem to have some market timing, but they require such frequent trading that by the time you factor in the transactions cost, no benefits remain. Finally, let's talk about market strategies. Many of the major investment banks have market strategies. They're pretty high profiles. You see them on CNBC talking about the right blend of stocks and bonds and cash to have in future periods. This graph from the Wall Street Journal, they compared the very best market strategies to what you'd have earned on a robot plan, like a 60/40 blend or a 100% equity blend.

8:27 The very best market strategies does beat a robot plan, but a fairer comparison is what the average market strategist does versus the robot plant. And guess what? The average market strategist seems to add no value to the process. It's kind of scary if you think about how much press they get and how much news they generate when they when they release their recommendations or views on the markets to the public. So, overall, when you look at the evidence on market timing, it's pretty weak to non-existent that there have been consistent market timers.

9:03 One final aspect of the time we live in is what we call finfluencers. What are finfluencers? These are people who don't have newsletters in the traditional sense, are not market strategies, but they have big followings on social media, on YouTube, on TikTok, on Instagram. In fact, in this graph, you look at which looked at these finfluencers, and it's still early in the game, and where they go, you can see how many of them are on TikTok versus YouTube and Instagram. The The differences seem to be on on YouTube, there are far more people who are promoting things, trying to sell you stuff.

9:42 You have a little more guidance from from TikTok and Instagram for influencers. Again, very early studies, but clearly the mix of people on the different platforms seems to yield very different views on what they bring, what they're trying to do. So, as you look at a finfluencer, one of the first places to look at is what platform are they using and what are they trying to do? Are they trying to promote something? Are they trying to make a recommendation? Are they trying to provide provide investment guidance?

10:13 And if you look at how well they do at market timing and predicting the market, it's still early in the game. Okay? Now, many of them still focus on meme stocks, so there's this insane amount of following that you get if you pick a meme stock or on cryptos, where again, you get following. And they've been lucky. They've been lucky in the sense they've been in a period where equity markets have for the most part gone up. Bitcoin has gone up in a hundredfold over the last decade.

10:41 And it's easy to look good when markets are doing well. The test of market timing is when you're under duress, and many of these finfluencers have not been in a market under duress. And my prediction is that when there is a market under duress, you're going to see some shaking up, that you're going to separate the wheat from the chaff here. And it's coming because, you know, it If you look at much of the advice, it's shallow, it's based on not facts, but opinions. It's it's it's a very very it's a very mixed, very volatile place to be in terms of getting investment advice.

11:19 So, as an investor, you know, given all of the things we've said about market timing, you can choose not to time markets and stay away from saying, "It's not for me. I can't do it." But if you decide to bring market timing into your portfolio into your investment game, there are four ways you can do it. One is you can adjust your adjust your asset allocation to reflect your views on markets, right? And we all do it, I think, implicitly even when we claim we don't.

11:46 The second is to switch sectors or styles based on where you think the market is going. What I mean by that earlier on as we talked about different investment philosophies, we talked about how some philosophies do well in certain types of markets. And maybe if you're a market timer, you might be able to take advantage of those shifts over time. And finally, you can go all in and say, "Look, I'm a market timer. I'm going to bet on market timing and essentially try to make your money on just making big bets on market direction."

12:20 Let's start with the asset allocation changes. Asset allocation changes, as I said, you start with an asset allocation mix that reflects your views on risk aversion, your age, your liquidity needs. And you can then you bring your market timing to adjust that asset allocation away from what you'd have picked if you didn't have market timing views. Put simply, if your if your risk aversion would have led you to 50% stocks, 50% bonds, but you think stocks are cheap and bonds are expensive, you might put 80% in stocks and 20% in bonds.

12:53 The extreme version of this is you go 100% into those assets that you think are underpriced and 0% stocks are overpriced. But that's an asset allocation change. Second is is style switching. If you remember our conversation on value versus growth investing, and we looked at the year-to-year difference, while over the long term, low PE stocks have beat high PE stocks, in extended stretches where high PE stocks did better. And then you dig a little deeper and you look at when that happens, it turns out that both small cap and growth investing do much better when growth is low.

13:33 And the yield curve is downward sloping. You're saying, "So what?" You might think your competitive advantage is forecasting when growth is going to be low. So maybe you're good at doing that. And if you can do that, then you can pick a philosophy that'll do well when growth is low, which would be growth and small cap investing. One study that looked at investor with perfect foresight, basically switching between and growth stocks just ahead of those shifts that you saw in that long-term graph of value versus growth, you know, not surprisingly, would have you would have earned much higher returns than somebody who couldn't have made that switch.

14:09 So if you're a good market timer, the second way this might play out rather than through asset allocation is what kinds of stocks you own. So if you think stocks are going to go up, you might shift to value stocks. But if you think stocks are going to be, you know, you're going to you know, be in low growth period, you might shift to growth stocks. And that might make you higher returns over time because you got the timing right.

14:30 This is a graph that's a throwback to the last century. In the last century, in fact, if you looked at US equity markets, it followed a very tight script where sectors actually rotated through as the market went up and down. So certain sectors did well when you're in a in a full recession, certain sectors jumped on the bandwagon fast in early recovering. And if you buy into this sector cycle, here's what you're going to do. You're essentially going to use your views on the market and the economy to sector shift. Shifting out of cyclicals to industrial to energy to services to finance. And now, of course, you got to bring technology into the mix and look at which sectors do well and what types of markets. Again, a version of market timing showing up less in asset allocation or even in style and more in what sector does you own in your portfolio.

15:25 And finally, of course, you can speculate. If you're If you really have enough confidence in your market timing, you can go out and make a bet on it. It's a high-risk, high-return strategy, as we saw at the very in a very introductory session, the reason people are drawn to market timing is if you can do it right, you're going to do much better than somebody who picks stocks. The high-risk, high-return strategy. And if you can pull it off, I mean, that's you know, you're going to look much better than investors who are picking individual stocks.

15:55 And of course, you could put this entire strategy on steroids if you use leverage, by either borrowing money to buy stocks if you think stocks are underpriced, or buying call options, which is essentially the equivalent, right? Because because you're effectively using leverage. Either way, you're making a bet on your market timing being right and taking And as I said, high-risk, high-return. So, let's summarize. Market timing it draws people because of the huge payoff you get if you're right.

16:26 Everybody does it. Even people who claim not to do it. Some do it subtly by changing the amount of cash they have in their portfolio. Some are explicit, actually bet on market timing. With all that said, though, history's not been kind to market timers. In what sense? If you look at the 100 years plus that we have information about markets and who's been playing on markets, it's very difficult to point to people who've been consistently successful with market timing.

16:54 In fact, every correction or big move up brings market gurus to the surface. These are people who got that big move right, but if you track them over time, they're more like shooting stars. They don't seem to survive the next cycle. With all of that said, though, it's a choice you have to make of how much market timing you want to bring into your portfolio analysis. And remember, don't make it an either/or. You can be both a stock picker and a market timer.

17:21 And often, you can have the same philosophy driving both. If you're an intrinsic value person, you might say, "I will buy stocks because they're cheap on an intrinsic value base." And you would bring that same perspective to markets. The same views you have about markets overreacting or learning slowly can drive both your market timing and your security selection. The two caveats I would have is if you have different skills as a stock picker and a market timer, it behooves you to keep track of how good you are at either. Cuz if you're really good at one and not that good at at the other, you need to know where your where your where your differential advantage lies. And if you find that your attempts at one are undercutting the other, let's say that you're a great stock picker, but in trying to time markets, you're actually hurting yourself.

18:07 You might want to abandon the market timing component of the philosophy and focus just on the stock picking. Being aware of what works and doesn't work for you is a key step in financing and fine-tuning your investment philosophy. I hope you found the session useful, and I thank you very much for listening.