The Perils of Market Timing
By Whitney Tilson (Tilsonfunds@aol.com)
NEW YORK, NY (Dec. 27, 1999) -- It seems like every time you open the newspaper or turn on the TV, some "expert" is calling the stock market overvalued. In fact, according to an article on the front page of yesterday's New York Times business section, "close to half of the large brokers and investment advisors... are bearish on the market." The explicit or implicit recommendation is that you should sell your stocks and then buy back later when prices are cheaper. As I wrote in my columns on November 8 and 15, I don't know if the market is overvalued, and for long-term investors I don't think it really matters. But I have a strong opinion on the short-term market forecasts that are constantly being peddled: You should ignore them. As Warren Buffett wrote in his 1992 Berkshire Hathaway shareholder letter:
"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."
Peter Lynch echoed these thoughts in his book, One Up on Wall Street:
"Thousands of experts study overbought indicators, oversold indicators, head-and-shoulder patterns, put-call ratios, the Fed's policy on money supply, foreign investment, the movement of the constellations through the heavens, and the moss on oak trees, and they can't predict the markets with any useful consistency, any more than the gizzard squeezers could tell the Roman emperors when the Huns would attack....
"The market ought to be irrelevant. If I could convince you of this one thing, I'd feel this book had done its job."
My main message over the columns I've written in the past couple of months is to ignore the fortune tellers and, if you invest in mutual funds or index funds, to steadily invest your long-term savings in equities -- personally, I'm a big fan of index funds -- regardless of how high the market seems (subject to the caveats in my column of December 6). And, if you invest in individual stocks, my advice is to focus on the long-term futures of the businesses underlying the stocks you own or are considering buying.
Yet the temptation to try to time the market can be overwhelming, and couched in the right words, can sound so reasonable. Here are excerpts from an e-mail a reader sent me on November 23:
"I am a long-term, buy-and-hold investor.... Regarding Y2K -- I have a gut feeling (hardly a basis for market timing!!) that there may be a 15-20% drop due to selling pressure as people pull their profits both because of the great run-up since October 28 and because Y2K just might create some 'flight to safety' thinking. Why should investors not avoid the downturn and pick up the huge upswing (in my opinion this will happen within the first two weeks in January when everyone realizes that planes haven't crashed and food is still in the stores)? It hardly seems like market timing to take advantage of a rather interesting scenario come Dec. 31 - Jan. 1.
"I just sort of hate to think of $500,000 turning into $400,000. I'd rather be out of part of the market on Dec. 20 and go roaring back in on Jan. 10. Maybe I'd miss a quick 10% pop, but maybe I'd miss a sudden 20% drop."
Funny how Y2K and the market's volatility and valuation levels are causing people who call themselves "long-term, buy-and-hold" investors to start singing a different tune, isn't it?
The Argument Against Market Timing
In a number of my recent columns, I endorsed a strategy of remaining fully invested despite the market's high valuation levels. To support this, I presented data in last week's column showing the superior long-term returns from equities, even if one had invested at market peaks. I want to continue the discussion by making the argument against the alternative -- trying to time the market by investing mostly in cash or bonds when the market is at or near a peak, and mostly in stocks when the market is cheap.
The problem with that strategy is this: How are you supposed to tell when the market is about to suffer a significant correction, or begin a major upswing? I am not aware of a single person who has been able to predict this with any consistency (though Buffett comes close, as I wrote in my column, "Buffett's Prescient Market Calls"). Lynch agrees:
"Nobody called to inform me of an immediate collapse in October , and if all the people who claimed to have predicted it beforehand had sold out their shares, then the market would have dropped the 1,000 points much earlier due to these great crowds of informed sellers."
The Costs of Imperfect Market Timing
Not only is it impossible to accurately time the market, but the costs of anything but perfect market timing are severe. Being out of the market during only a few of the best days or months can ruin a portfolio's long-term returns.
For example, consider these three examples:
A) Had you put $1,000 in the S&P 500 at the end of 1981, your stake would have grown to $25,584 (including reinvested dividends) by the end of 1998. But if you had missed the 30 best days (defined as the days with the highest percentage gain) of those 4,400 trading days, you would have ended up with $4,549, 82% less. (Source: Dow 100,000: Fact or Fiction.)
B) Had you invested $1,000 in May 1970 and held for 14 years, you would have $3,000. But if you had missed the five best days, you would only have $2,000. (Source: Against the Gods: The Remarkable Story of Risk.)
C) Had you invested $1,000 in January 1978 and held for 20 years, you would have $21,750. But if you had missed the 15 best months, you would only have $6,010, 72% less and only slightly better than the $4,080 you would have had from investing in T-bills. (Source: Ibbotson Associates, Stocks, Bonds, Bills and Inflation, 1997 Yearbook.)
Here's the final piece of data against market timing. Consider three people who each invested $1,000 per year in the S&P 500 Index from 1965 to 1995. Investor A bought on the first day of each year, Investor B -- the world's best market timer -- bought at the lowest price each year, and unlucky Investor C bought at the market's peak each year. Here are the results:
Investor A (invests on first day of the year): 11.0%
Investor B (invests at market nadir each year): 11.7%
Investor C (invests at market peak each year): 10.6%
As you can see, the differences among the compound annual returns earned by each investor are small. (Source: Peter Lynch, Fidelity Investments brochure, "Key Things Every Investor Should Know.")
I'll conclude with another quote from Lynch:
"I don't believe in predicting markets. I believe in buying great companies -- especially companies that are undervalued and/or underappreciated.... Pick the right stocks and the market will take care of itself.
"That's not to say that there isn't such a thing as an overvalued market, but there's no point worrying about it. The way you'll know when the market is overvalued is when you can't find a single company that's reasonably priced or that meets your other criteria for investment."
Using Lynch's definition, I'm a long way from concluding that the market is overvalued. While the valuations of most technology, Internet, and blue-chip growth stocks make me increasingly uncomfortable, I believe that excellent investment opportunities remain. There are a few high-quality, attractively priced value stocks such as Berkshire Hathaway (NYSE: BRK.A) and many outstanding smaller companies that investors can find if they are willing to do some work. I especially recommend the latter, as the opportunity to invest in smaller companies is a huge advantage that I -- and probably every reader of this column -- have over large money managers who have to make investments in the hundreds of millions, if not billions, of dollars to make a difference in their portfolios. We can buy as much as we want of even the smallest companies without having to worry about liquidity or moving the market. Examples of these stocks include a mid-cap stock, American Power Conversion (Nasdaq: APCC), which I wrote about in September and November, and a small-cap stock, Timberline Software (Nasdaq: TMBS), which was covered in the Rule Maker Portfolio in September.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilsonfunds@aol.com. To read his previous guest columns in the Boring Port and other writings, click here.