Does timing the market work?

“Our major obligation is not to mistake slogans for solutions.”
- Edward R. Murrow

I can’t tell you who originally said, “thinking is difficult, that is why most people don’t do it.” I’ve seen it attributed to Henry Ford who spent a lot of time thinking about assembly lines and groups of people he hated. I’ve seen it attributed to Carl Jung who consciously spent his time thinking about the unconscious. And I’ve seen it attributed to Einstein who seems to get credit for anything we think sounds smart. Whoever said it I believe in the sentiment.

One way we avoid thinking is to rely on maxims to govern our behaviour. In investing a popular one is ‘time in the market and not timing the market’. This seemingly contradicts other things we hear. The importance of investing only when valuations are attractive, the benefits of taking a contrarian view and avoiding the herd are some examples.

The issue is not the apparent contradiction in these statements. The issue is that without considering them fully we can use these pithy sayings to justify a wide range of actions. To try and raise the intellectual bar we ran the numbers at Morningstar to provide some food for thought.

Valuation matters

Morningstar recently looked back at our fair value estimates to determine what impact they had on returns. We used our US coverage list which includes almost 700 companies and explored data over the 21-year period starting in 2002.

We aggregated the individual fair value estimates for each share and weighted them by market capitalisation which is how major indexes like the S&P 500 and ASX 200 are constructed. This provides a fair estimate for the US market. Comparing the aggregated fair value estimates and prices allows us to determine if the market is overvalued, undervalued or fairly valued.

We then tracked the return after 3 years for each monthly fair value estimate. Returns were higher when the market was deemed to be undervalued than when it was overvalued. The outperformance was .76% a year. This may not seem like a lot but is significant over a long holding period. Investing $1000 a month for 30 years and earning a 7% return results in $1.169m. Earning a 7.76% return yields $1.346m.

It is tempting to extrapolate this into a strategy of buying when the market is cheap and selling when it is expense. That is the definition of market timing and further exploration is needed before coming to a conclusion.

What about buy and hold?

Purchasing cheap shares and selling expensive ones works better than the alternative. But we also need to compare this approach to an investor that simply bought shares at the beginning of the period and held them.

Unsurprisingly – at least to me – buy and hold outperforms a portfolio that is trying to time the market using valuation as an input into buy and sell decisions. In this analysis we tried to make it realistic and assumed an investor had additional cash to invest over the 21-year period.

What gets lost in many of the lump sum vs. dollar cost averaging conversations is that most investors don’t really have choice. Many of us save money each time we get paid and invest regularly. We don’t start out with a lump sum that can either can be invested in totality or parcelled out over time.

We ran a model that assumed that contributions were made into a portfolio on a monthly basis. In the buy and hold scenario the money was invested as soon as it was available. In the market timing scenario the money would only be invested if shares were undervalued. If the market was overvalued the cash would be retained until a time when the market was cheap again.

Over the aforementioned time period the buy and hold strategy outperformed market timing by 10% cumulatively or just less than 1% a year.

What made the difference between buy and hold and a valuation driven approach?

What held the valuation-aware strategy back? Cash drag. Though the strategy earned higher average returns when the equity screens indicated the market was undervalued, it was more than offset by the upside the strategy missed out on when those same signals showed the market was rich.

In other words, because stocks tend to go up over very long periods, it pays to be fully invested, even if occasionally going to cash might have taken some of the edge off at times.
It is also worth noting and that taxes and transaction costs were not included in this analysis. That would have eroded the return further.

How does this work on a practical basis

A buy and hold strategy led to higher returns. Investing in undervalued shares also led to higher returns. A prudent strategy may be to combine the two. Regularly invest but direct those investments to undervalued assets.

A simple example would be an investor with a portfolio made up of Aussie and US shares. If US shares were cheaper than Aussie shares monthly contributions would go into the US. If the inverse were true a month later the next contribution would be directed into Aussie shares.

This is easier said then done. By aggregating all of our analyst fair value estimates on individual shares we’ve essentially created an index. Selecting individual shares adds another element to this exercise. The individual share selected would have to replicate the results of the aggregation of all our analyst ratings. In other words, you need to pick the right share. Something that a large proportion of value investors fail to do.

If multiple indexes were available to an investor – which they are – an assessment would just have to be made on which index to choose for each contribution. Also, a challenging endeavour. And it is important to note that our analyst fair value estimates are based on a discounted cash flow (“DCF”) analysis of a share. They are not using the relative valuation measures (like a price to earnings ratio (“PE”)) that are used by indexes that track value and growth strategies. A share with a PE of 30 can be undervalued and one with a PE of 10 can be overvalued using a DCF analysis.

At the very least this should give investors something to think about. Some investors may recoil at the intellectual challenge of trying to determine the cheapest areas to direct funds. Perhaps just picking a single index and taking a buy and hold strategy will be the best approach for this group. Some investors will spend time thinking about how to implement a strategy that combines the best of both findings. All investors should appreciate that an investing maxim isn’t as straight forward as it seems.