Friday Morning coffee Nr 80 - Forget market timing!

As value investors, we are frequently being asked about market timing. Our standard answer is the famous quote from Benjamin Graham : “In the short term markets are a voting machine, in the long term a weighing machine”. As long-term investors, we do not see our value added in forecasting the market short term as we believe pretty much anything can happen. This does not mean that we simply lean back and wait till our investments reach our fair value. On the contrary, we follow our businesses closely in order to detect early on any change in the fundamentals of the business that could impair its earning power and ultimately our investment case. What we are NOT doing is trying to time different asset classes, use cash in the portfolio as a tactical weapon to absorb short term market drops or time our allocation to different investment styles, like momentum, low volatility or value, depending on where we think stock markets will go in the short run.

"The price of being out of the market and missing out during the best trading days of the market is excessively high"

Wim Antoons, Head of portfolio desk at the Belgian multi-family office Portolani and a well-known value investor, recently published a study called “Market Timing : Opportunities and Risks” that appears to comfort our view on market timing. In the extensive research note, Wim explores the limits of tactical asset allocation and market timing. To be clear: it is very tempting to try to time the markets. For example, 1 USD invested into 20 year Govies in 1926 would have returned 142 USD at the end of 2018. 1 USD in the S&P 500 would have returned 7.070 USD in the same time frame. A tactical allocation where the investor would have allocated every year 100% to the coming years best performing asset class between cash, 20 year Govies and the S&P 500 would have returned a stunning 5.115.473 USD. The only two caveats to this strategy are that first you needed to forecast the direction of the markets correctly year after year over 92 years and second, you did not incur transaction costs. Unfortunately, I have not heard of any investor who managed to do that consistently. 

The price of being out of the market and missing out during the best trading days of the market is excessively high as shown in the graph below from the study that illustrates the impact on your end capital by missing the best trading days.

Source: Market Timing: Opportunities and Risks by Wim Antoons 

To make matters for our market timer even more tricky, Wim shows that the best and worst trading days over the last 60 years on the US stock market tended to cluster. In other words, the worst days in the stock market in terms of performance were historically usually surrounded by its best days. Therefore, if the investor avoided the crash by stepping out at the right moment, chances are that he was not back quickly enough to profit from the market rebound.

Transaction costs also matter in the long run. These may include the front- and back-loaded fees for mutual funds, commissions on trades as well as capital gain taxes. A 1.5% lower return due to costs compounded over 20 years results into a 31.1% lower final capital over 20 years as shown in the study.

 As Wim illustrates in his work, empirical evidence show that market timing is extremely difficult. Market-timing newsletters, fund managers, mutual fund investors, technical indicators and even long-term valuation measures appear not to be efficient forecasting tools for short and mid-term direction of the market.

 At ECP, we are humble enough not to try forecasting the direction of the market in the short run. We invest in companies that trade at a significant discount, or margin of safety, to what we think they are worth based on our fundamental analysis. We sell when our fair value is reached. Our current cash position is below 5%: it is the residual of what investments we sold and what opportunities we find. We are humble enough not to use cash as a tactical asset allocation tool.

 I wish you a nice weekend,

 Léon

 PS: Many thanks to Wim Antoons for allowing us to use some of his work.

You can find this article on European Capital Partners' website.

Important notice: This document is published for information purposes only and gives the opinion of the author at the time of the publication. It does not constitute an offer to buy or sell financial instruments or investment advice and does not confirm any transaction unless expressly agreed otherwise.