No One Can Time The Market

https://theirrelevantinvestor.com/2018/11/20/timing-the-mark…

You invest in stocks (S&P 500) when they’re below the average CAPE ratio, and you sell them when they’re above. A quick note on this- some analysis assumes that an average from inception until today was available 50 years ago. Needless to say it was not, so for this strategy I’m assuming that the investor only uses the data available at that time.

The chart below shows the growth of $1 if it invested in stocks when they’re below the average CAPE ratio, and sell them when they’re above the average CAPE ratio. The buy/sell occurs on the last day of the month and when stocks are sold, the money goes into 5-year U.S. treasury notes.

From 1926-1955, this strategy had the same returns as buy and hold, 9.9% a year, turning $1 to $4.10.

It also experienced less severe drawdowns, although it still got crushed in the Great Depression, like everything else.

But then something changed. The strategy stopped working.

Below are the returns from 1955 to today.

So what happened? Well, maybe this is just a crummy strategy that “worked” for thirty years. Or maybe the nature of the CAPE ratio has changed over time. From 1926-1955, this would have kept you invested in stocks 68% of all months. From 1955-today, this would have been invested just 25% of the time. The chart below shows the average CAPE ratio in real time (black) versus the CAPE ratio going all the way back to the beginning of the data series.

The average CAPE bottomed in 1955, and has been on the rise for the last 30 years. Which explains a lot of why this strategy would have done horribly in the last few decades. The chart below shows the S&P 500 (black), and when this strategy would have been in bonds (red). As you can see, from 1990 to today, the CAPE ratio was above its average 98% of the time.

So, Cliff was right when he said “You do not want to make a career trying to beat the stock market based on whether it is cheap or expensive.” But what if there was a better way to define expensive? For this next backtest, I assumed you were invested in the S&P 500 and only rotated into bonds when stocks closed one standard deviation above their average (also real time, trade on last day of the month).

The chart below shocks the CAPE ratio in black, the average across time in gray, and 1 standard deviation above the average in red.

Interestingly, this strategy kept pace with buy and hold from 1926 all the way to 2013.

But it would have you in bonds for the last 63 months, missing out on an 82% gain for the S&P 500.

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The answer is easy. The United States became the premiere hub of economic activity following W.W. II. The rest of the world was destroyed. The majority of capital flowed to the United States. This capital was put into increasingly increasing return businesses that today have resulted in SaaS, cloud, AI and the like. Where bits and bytes replace steel and oil, and where these same bits an bytes make this same steel and oil far more efficient to produce.

The gains in efficiency since 1955 have been historically unprecedented in human history. Nothing comes close. At the same time the majority of capital flows to the U.S. And as things are going there is no slow down in efficiency gains, and there is no slow down as to where capital is flowing. China is a very large emerging market, with tons of investment, and at some point it may become the largest consumer market in the world. But China will never be trusted as the United States is, and it is still a long time until the United States is not the center will investing capital flows, and increasing returns technology and business models are either invented or go, to proliferate.

Not difficult to see why this CAPE failed. What I do find is academians have too little real world experience to interpret their numbers. I saw it at Duke, I have seen it in business, and I have seen it in law practice. The one thing that always gave me an edge (even as I am far from the brightest of people I have dealt with) is the experience I have had from all ends of the social spectrum and through so many varieties of life experiences. It enables one to better take the numbers academians put together and interpret what they really mean.

So many people on the Fool have just as much or more such experience that the standard academian does not.

That is the reason why. And I am not counting out this continuing trend simply because we hit a rut. All human endeavors hit ruts. It is getting over the ruts that defines the success humanity has had. It is trying to eliminate ruts or just not care to get over ruts that defines abject misery and failure in human history.

Tinker

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A few things Asness said in a recent podcast -
“Don’t try to make a career timing the stock market based on value factors alone” - you would have been flat for over 40 years.

CAPE is a value factor.

“Trend and momentum are a little more powerful than value, but value is harder to compare over time.” 1 year price momentum is pretty robust for timing.

Valuation should matter but all valuation does is forecast an average expected return over the next n (10?) years. When markets have been this overvalued in the past, the average forward return is @3% annually. That valuation - and forward return expectation - can be changed in a number of ways: recessions, bear markets, growing earnings, time.

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