In Defense Of Market Timing (Sort Of)
Summary Typical studies that demonstrate why market timing is a bad idea have a fatal flaw: They’re not so much “market timing analyses” as “perfect market mis-timing analyses.” The options market gives us a feel for how to recast the problem. Some practical thoughts on actual pros/cons for market timing. We’ve all seen the studies, and the conclusions are the same: it’s not about tim ing the market, it’s about time in the market (tell that to the Japanese). I’d like to discuss why there are fatal flaws in the classic study put forth to investors, a study which seemingly demonstrates why market timing is a bad idea. But before going further, I would like to point out that I am attacking the typical anecdotal study, not the overall advice. This piece is not an endorsement on market timing. First, I present the typical kind of reasoning that is set forth for why one should never attempt market timing. This is one particular case, but there have been many variations presented throughout the years, and most investors have been exposed to one or more of them. From Horan Capital Investors : Making ill-conceived market moves can reduce the growth of one’s investments substantially. The below chart graphs the growth of the S&P 500 Index from 1990 through June 30, 2015. The blue line displays the growth of $10,000 that remains fully invested in the S&P 500 Index over the entire time period. The yellow line shows the same growth, but excludes the top 10 return days over the 25-year period (6,300 trading days.) By missing the top 10 return days over the 25-year period, the end period value grows to only half the value of the blue line that represents remaining fully invested. (click to enlarge) Chart source: Horan Capital. Wow! Pretty compelling. Missing out on just the top 10 days out of 6300 cuts my total return in half! Market timing must be a terrible idea, right? There are many very legitimate reasons to argue against market timing, and I’ll discuss some of them in the conclusion. But first, let’s dig deeper to see if there’s anything interesting taking place during those 10 “best” days. Indeed, the cumulative return for participating in those 10 best days amounts to 100% – but look at the dates! The dates these earth-shattering returns occurred teach us some valuable lessons. Two of the dates were March 10 and March 29, 2009 – the furious beginning to the new bull market. It would indeed be tough on an investor to miss those dates, as the train was leaving the station. Bull markets often begin with strings of giant gains, and as such there probably should be some plan to get back in if you dumped your stocks and have plans to rejoin. On the other hand, eight of the dates were merely bursts with plenty of room left for the market to fall. If you got out – and stayed out – the day before any one of those great days, for 3+ months, you’d have been very happy that you had missed both the huge rally as well as the ensuing freefall. In fact, if you got out just before the 9/30/08 5.25% gain, you could have stayed out for the next three years and not lost out on a penny of gains, even though 2.5 of those three years were part of the new bull. Big up-days happen when there is outsized volatility. The trouble I have with studies like the Horan study is that they effectively show you what would have happened if you were an absolutely perfect market mis-timer. Now granted, haven’t we all felt like we were perfect mis-timers? I sure have, and I’ll bet you have too. But this study – and multitudes like it – actually quantify for you how costly being a perfect market mis-timer would be: in this case a doubling of your capital. To further understand why the Horan study asks the wrong question, let’s invert it: How much more money would you have if you only missed the ten worst days in the market? Here they are: Missing the worst ten days in the last 25 years for the S&P would have more than doubled your money! Furthermore, nine of those ten times (1997 excluded), you could have gotten out after the bad day, and still have been happy for several weeks or months to come – even though you would have missed some monster rallies along the way (consider how closely the best and worst days are clustered). Taking aside taxes, transactions costs, and the like, if you could side-step the best ten and worst ten days, you would have been better off to have missed both. Participating in all twenty of those spectacular days cost you 7% cumulative of your ending balance. This is likely not just a fluke, as the stock market has long been known to exhibit negative skew, where the log-magnitude of big down-days are larger than for big up-days. The options market lends insight on the matter. (click to enlarge) Look at the VIX prints for the close of each of the prior days. If we plug those VIX levels in for a one-day option price calculator, struck at the close the prior day, we obtain the call price column. I’ll add that there’s a very good chance that the VIX would have been in backwardation during many or all of these dates, and so the actual call premium would likely have been higher still. If you had hedged your SPX holdings by selling a one-day, ATM call against your position, you would have reduced your SPX winnings relative to not hedging at all. But you would have earned 16% in total call premium, and as such the missed opportunity would have netted to 72% rather than 100%. This highlights two big ideas that are each worthy of note. First, if you sold a one-day call just before one of these hall-of-fame days, then you had some terrible luck: you sold a lot of gamma one day before a giant move. But notice that the options market was at least pricing in very large swings in all ten of these cases. Your missed opportunity, while still large, was dampened considerably. Put differently, your missed opportunity was unfortunate, but predictable. Second, I think framing the study in terms of the ultimate unlucky options trader demonstrates just how unlikely being a perfect market mis-timer really is. Think about it: what are the odds that you would sell one-day ATM calls, ten times in your entire stock-holding career, with each instance being met with one the ten best days in the last 25 years? ZERO! But that’s the same likelihood that you would just miss only the ten best days, and nothing else (forget the options). What if you sold a one-day, ATM option every day, including on some of those worst days? Perhaps the 72% you had missed out on would largely (or more-than-fully) be recouped. Conclusion Studies of the Horan variety above are simply not serious studies of market timing. It doesn’t mean that they don’t offer insight, but they give it in a way that clouds a greater reality. Being a perfect market timer would be amazing — but that alone is not a reason to attempt it. Likewise, being a perfect market mis-timer would be horrific, and that alone is no reason why you should avoid it. There are good reasons for avoiding market timing, but they have nothing to do with the study (quite the contrary; I’d argue that the study recommends running to high ground early and waiting for the dust to settle). Here they are: Transactions costs: lots of portfolio churn needs to be carefully considered. You need to think about what the broker, and what the market maker, is earning off your trade. It does not mean you shouldn’t trade, but it is undoubtedly a con rather than a pro. Taxes: tax losses are treated asymmetrically from tax gains, which skews your after-tax risk profile. That is a perfectly legitimate reason to avoid “market timing”. Psychology: This is by far the biggest reason investors shouldn’t time the market. Investors and traders are not the same animal. They have different skill sets, different perspectives, different goals. Traders time the market almost by definition. Most fail, and a few do quite well. Investors should not be market timers precisely because being a market timer has a lot in common with being a trader, and very few investors are good traders. Imagine morphing from being an investor (something you might be good at) into being a trader (something you are probably bad at) at the worst conceivable time. Look at those dates for the best 10/worst 10 days – what a nightmare! Is that the kind of environment where you want to consider shifting away from what you do know toward what you do not know? This is the real reason that investors should not attempt to time the market. Finally, when SHOULD an investor open or close a position in a meaningful way? I mean, couldn’t we describe any buy or sell order market timing of sorts? Is it part of your overall strategy? Do you have a lot of cash – waiting for weeks, months or years to get in, and then when the market falls, you get out? That’s undisciplined selling: that’s an investor acting like a trader. Note from the discussion above that there’s an outstanding chance that your “trade” will go well and you’ll be happy you panicked, at least for awhile. If that’s you, you should be asking: “When do I plan to get back in? Proverbially or literally speaking, what put option will I sell TODAY to lock me into getting back in should the market actually fall that low and I lose my nerve?” On the other hand, maybe you are selling because this is part of your discipline. “Ride my winners, cut my losers.”; “I don’t hang around in high-vol environments hoping for a recovery (they don’t all end with a V-bottom!)”. This is a legitimate reason to “panic” and sell: it’s part of your strategy. While you might be unhappy if the market rebounds, you did the right thing, even if you got the wrong result. Maybe you should tweak your strategy, ex post. Maybe the market is showing you that your strategy has some meaningful flaws that you never considered or took seriously. Reducing your position size – even to zero – could be prudent. It’s one thing when markets are going from bad to worse and it’s part of your discipline. It’s quite another when you never foresaw the eventuality that you’re in, and volatility is heavy on the market. You’ll know this to be the case when you are asking yourself – as an investor – serious questions about your own long-term investing style. You’re not considering “a trade”, you’re considering a change. Best of luck, I hope the bulls need it!