After the recent strong stock market gains, I have been asked a few times lately: “What should we do to protect against a possible market downturn? Should we become defensive?”
If you could move in and out of the market at the right time, you would obviously increase your returns and avoid some losses. On the other hand, many of the best investors, such as Warren Buffett, tend to stay invested all the time. What is the most effective strategy?
Let’s look at timing the market and how we could do it.
The most important part of timing the market is to get the general direction right. There are all kinds of predictions, but to keep it simple, let’s categorize your prediction for the next year into one of the four in the chart.
Table 1: S&P500 since 1950. Source: Standard & Poor’s
What’s your prediction for the next year?
If you are predicting an “up a lot” or “up a little” year, you would want to be fully invested. That means you need to be fully invested at least 3 years out of 4. The biggest risk of market timing is missing the 76% of years that are gains.
Most years, you would probably predict a “normal” year – right? Note that “normal” returns are abnormal! On January 1 each year, the media publishes predictions by many financial experts. Most predictions are in the normal range. Since the stock markets average a bit over 10% long term, you would expect most years to be somewhere between 0% and 20%. However, more than 60% of years are abnormal.
If you are predicting a “down a little” year, it is probably not worth changing your investments. The issue is that what if you are wrong? The human gut is almost always wrong when it comes to investing. And remember there are three times as many gains.
How much would you gain anyway if you are right? Remember, you would have to be right both in the timing of selling and buying, and you may incur some costs and tax consequences to make changes. The “up a little” and “down a little” years could also easily have turned out differently in a couple months at year-end.
Unless you are very sure of a down year and you know you have your human gut in check, it is rarely worth it to try to avoid a “down a little” year.
Predicting bear markets
Where market timing could make a big difference is if you could avoid the “down a lot” years, or the bear markets. If you could be fully invested all the time, except just avoid the bear markets, you would outperform significantly.
How do you see a bear market coming?
The first thing to remember: “Bad news doesn’t hit you between the eyes. It hits you in the back of the head.”2 Most predictions of bear markets happen when there is well-publicized bad news expected. For example, recently we had fears of a collapse of the European Union and U.S. debt fears. Bear markets almost never result from anything well publicized ahead of time. Can you think of any time in history when bad news was widely predicted, then actually happened and after that the market falls?
Probably the only way to predict a bear market is to see a market bubble. The issue here is that true bubbles are rarely identified as bubbles. Hardly anyone thought energy was a bubble in 1980 or technology in 1999. Both times, everyone thought “this time it’s different”. The internet was going to change the world. Remember “The New Economy” and “clicks, not bricks”?
Bubbles are really about extreme overvaluation. The mood is usually euphoric with many people predicting continued large gains.
There are issues with predicting bear markets, though.
First, remember that there have been only 3 “down a lot” years in the last 63 years1, which averages to one every second decade. If you are predicting them more often than that, it is probably your Stone Age human gut creating false fear. Many people predicted another bear market after 2008, but few predicted one before. The people that correctly predict bear markets are often the “permabears” that are always pessimistic. I know 3 people that correctly predicted the 2008 crash and moved all their investments to cash before the drop. Great for them, right? The problem is that, last I heard, all 3 are still in cash today. Being permanently pessimistic is a disaster, since it means you will miss the 76% of years with gains1.
Second, if you correctly predict a bear market, you need to get invested again quickly. All three “down a lot” years where followed immediately by one or two “up a lot” years. Predicting the bear market is useless unless you buy in lower than you sold!
Third, make sure you know something few investors know. If you are only responding to scary news articles about well-publicized fears, the market has probably already accounted for them in its current price.
The last 2 bear markets show some of the issues. Each one is different. The market was not overvalued before the 2008 bear market, which is part of why few predicted it. In retrospect, the technology bubble was a clear overvaluation and bubble that could have been identified ahead of time. The issue is that the market was already overvalued in 1997. If you sold then, you missed the 3 big gains from 1997-1999 before you correctly avoided one big loss.
The reason predicting a bear market is so challenging is that if you miss even one of the “up a lot” years, you will probably underperform long term.
Today, many people are skeptical of recent market gains, and are expecting a downturn soon. However, there is no sign of euphoria or overvaluation. The market P/E is about 143, which is below the long term average. What’s more is that we just had a bear market. Remember that we should only expect one about every two decades. I believe that the skepticism today is mostly Stone Age human guts overreacting to fear and still remembering the pain of the recent crash in 2008.
Buy and hold investing
The difficulty in correctly predicting a bear market, getting the timing right, and not missing out on all the up years, is why, In general, it is best to be a “buy and hold” investor. The key to successful stock market investing is to be fully invested during the 76% of years that are gains.
The stock market has very reliably produced large gains long term. If you invested $1,000 in 1950, you would have $749,330 today1. “Buy and hold” investors can get the long term gains of the stock market. Market timers are far more likely to get lower returns.
Predicting bull markets
Should we give up on market timing altogether? From my experience, there is one type of market prediction I have been able to do successfully – predicting an “up a lot” year after a bear market. Markets have historically almost always bounced back quickly. The 3 bear markets since 1950 were all followed immediately by one or two “up a lot” years. The 27% drop in 1974 was followed by a 72% gain in 1975-76, the 22% drop in 2002 was followed by an 82% gain in 2003-7, and the 37% drop in 2008 has been followed by a 73% gain in 2009-20121 (which may be larger after 2013).
These predictions require no great insight on my part – only the assumption that the market will always recover.
In my opinion, the best investment strategy is to be a buy and hold investor (to be fully invested) all the time. Then once every decade or two, there will be a big sale – an opportunity to invest more at a discount of more than 20%. Taking advantage of every bear market is an easy way to beat the market.
My prediction for 2013
I don’t usually make short term predictions, but I do always have opinions. Certainly one of the most reliable indicators is that the popular sentiment is usually wrong, since it is already priced in. Most financial experts and most amateur investors today are predicting either a “normal” year or another downturn. Therefore, those two scenarios are unlikely.
We are starting year five of this bull market, but we have not yet had the normal gain from the last market peak. Sir John Templeton’s quote explains a lot: “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” The mood I see from investors today is skepticism, which is why my opinion is that we are only on second base in this bull market.
Considering that the market is very cheap (especially compared to bonds), sentiment is overly skeptical and the markets have not yet had their normal gain in the last 6 years, in my opinion the most likely scenario for 2013 is an “up a lot” year.
1 Standard & Poor’s
2 Oscar Belaiche
3 Wall Street Journal. S&P500 forward P/E: http://online.wsj.com/mdc/public/page/2_3021-peyield.html