An Exploration of Timing the Market - Alternative Strategies - Lake Street Advisors

Economist John Kenneth Galbraith famously said, “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”

His words underscore a popular issue in investing–timing the market.

As the current bull market nears its ninth year, clients commonly ask us “what should I do about it?” Since the bull market began on 3/9/2009, the S&P 500’s total return has exceeded 370%, small cap equities (S&P Small Cap 600) have returned more than 470%, and international equities (MSCI EAFE) have “only” returned 190% as of 12/31/17¹. Following the investing adage “buy low, sell high”, your gut tells you it’s time to get out of the market. Exacerbating these fears, industry pundits are constantly predicting major corrections in the stock market.

Market Timing: The Problem with Forecasting

Investor obsession with market forecasts is understandable. Successfully timing the market can be enormously profitable and has launched many investment managers into stardom. The problem with forecasts is that even the experts are not very good at them!

According to billionaire investor Howard Marks from Oaktree Capital Management, successful investment forecasting requires the following²:

1. The forecasts have to be sufficiently different from the market consensus.

• If a market prediction is already priced into the market, the payoff for a correct prediction will be relatively low. After considering the external costs of implementing these predictions, such as taxes, transaction costs, and fees, even making correct forecasts the majority of the time may not lead to above-average returns.

2. The forecasts must be consistently accurate.

• Successful forecasting requires going against the grain, but it also must be accurate. For example, there are numerous industry pundits who consistently predict that the stock market is headed for a correction or crash. While they will be right every once in a while, this is not a useful prediction if they are wrong 8 out of 10 times.

3. The forecasts must be timely.

• Industry forecasters often make predictions like “the market will eventually correct”. This prediction is not useful because it does not consider the opportunity cost of staying out of the market. The market will eventually correct, but that does not mean you will be better off if you go to cash versus staying in the market.

Achieving these three objectives can be difficult, and the task is made more complex after you consider external pressures with which forecasters are typically faced. For example, if a mutual fund manager makes a contrarian prediction that ends up being incorrect, performance will suffer on a relative basis to that manager’s peers. Investors will likely withdraw funds, which will lower the fund manager’s compensation, and may eventually lead to him losing his job. Alternatively, the manager could make a consensus forecast and maintain his lifestyle with relatively little worry. These types of dynamics create a strong incentive for forecasters to not stray very far from their peers, even though these are the types of predictions that provide the least value.

The Track Record of Forecasters

There have been numerous academic studies that test whether the experts can successfully time the market. On average, it has been found that the following groups have failed to time the market³:

• Asset Allocation Funds
• Investment Clubs
• Pension Funds
• Investment Newsletters
• Mutual Funds
• Professional Market Timers

For individual investors who often trust their “gut”, the results are even worse. According to Dalbar, the average annualized investor return in equity funds was 3.66% vs. 10.35% for the S&P 500 from 1986-2016. While there were other factors that led to their underperformance, Dalbar concluded market timing was the primary reason⁴.

So, What Should You Do? – Marketing Timing Alternatives

Instead of trying to time the market, we tell our clients that they should focus on other aspects where they have more control and where their probability of success is potentially higher. These other opportunities include:

• Diversification beyond US equities into other asset classes, including bonds, international equities, emerging markets, real assets, and low correlation alternative investments.
• Focusing on high level asset allocation and risk, which is the main determinant of future returns.
• Minimizing costs such as taxes and investment management fees.
• Rebalancing as needed, which in most cases includes reducing equity exposure after the market’s strong performance.
• Active manager selection in areas of the market with greater inefficiencies (including hedge funds and private equity if appropriate).

While we do not believe that markets are perfectly efficient, timing the market is difficult at best. At Lake Street, we focus on the aspects of investing that we can control and plan accordingly for those that we cannot.

Sources:

1. FactSet

2. https://www.oaktreecapital.com/docs/default-source/memos/1996-07-22-the-value-of-predictions-ii-or-give-that-man-a-cigar.pdf?sfvrsn=2

3. https://www.vanguard.com/pdf/s700.pdf

4. https://www.forbes.com/sites/johnbuckingham/2017/04/03/the-cost-of-market-timing/#491f5b2932ab