The investing community is a funny place. In general, we all tend to put ourselves into certain investing categories – dividend growth, total return, value, growth, income, and many others. And, in general, we tend to think whatever investing methodology we’ve chosen is the best one. This of course makes sense. After all, why would you choose an investing path that you don’t think is the best one, right?
And, as can be expected anytime there are people with varied opinions about any subject, disagreements arise. The growth investors think the value investors are too conservative, the value investors think the dividend growth investors are too focused on dividends and are opening themselves up to capital losses, etc.
However, there appears to be one thing that unites all investors – a near universal disdain for the idea of market timing. Judging by the comments I’ve seen, market timing is only slightly below genocide and childhood cancer on the list of the worst things in the world.
So what exactly is market timing? There’s no universal definition, but based on the discussions I’ve seen at Seeking Alpha and on various blogs, any mention that the stock market might be overvalued today is market timing.
In fact, this is so common that I’d like to propose a new law – Money Commando’s First Law. Money Commando’s First Law states “As an online investing discussion grows longer, the probability of an opinion on market valuation being mischaracterized as market timing approaches 1.” Note: this is a variation of Godwin’s Law, which states “as an online discussion grows longer, the probability of a comparison involving Nazism or Hitler approaches 1.”
I like to think of market timing this way – market timing is the attempt to predict the short-term movements of the market and profit from them. This means buying today if you think the market will go up in the short-term and selling today (or even selling short) if you think the market is going down in the short-term.
Does market timing suck?
Why so much hate for market timing? Well, the main issue with it is that it has proven to be impossible. Nobody knows where the market will be tomorrow, or next week, or next year. Despite the huge number of investing newsletters and talking heads on TV predicting where the market is going, nobody has been able to reliably predict the market. If they did, they sure wouldn’t tell you about it – they’d be making a killing in the stock market.
Another strike against market timing is that it’s typically associated with trading. If you think the market is going up tomorrow then you buy today. If you think the market will be lower next week then you sell short today and plan to buy at lower prices next week. The transaction costs (and taxes) associated with these kinds of trades eat up any profit you might have made.
Bottom line – trying to time the market just doesn’t work.
Investing is different from market timing, but still risky
Investing is a risky activity. You try to minimize the risk by researching a company’s financials and the market for the company’s products. You project how much money you think the company will make next year, in 5 years, and in 10 years. You compare the current price to the valuation you’ve calculated and decide if you want to buy. In any one of these calculations there’s uncertainty, and when you multiply all that uncertainty together you get even more uncertainly.
And in addition to the risk associated with any one company, investors also deal with currency risk, default risk, inflation risk, and a bunch of others.
Your goal as an investor is to generate the highest return for any given level of risk. How do you do that? By putting the odds in your favor as much as possible.
How to think about investing odds
Let’s say that you’re given a chance to gamble on a new kind of game. The game is pretty simple – it uses a single coin, an arrow, and a board with the numbers 1 through 9 laid out in a straight line. At any given time the arrow is pointing to one of the numbers on the board (again, 1 through 9).
The game is played like this – at the beginning of the game the arrow starts on the 5. The dealer then flips the coin 10 times. Each time the coin is flipped, if it comes up heads then the arrow moves up a number (from 7 to 8, for example). If the coin comes up tails then the arrow moves down a number (from 8 to 7). If the value is at a 9 and a heads comes up or if the value is a 1 and tails comes up then nothing happens.
At the end of the 10 flips the marker is on one of the numbers from 1-9 – this is the starting number. You’re now given the opportunity to bet. If you decide to bet then the dealer flips the coin 10 more times and moves the marker each time, eventually resting on a number after 10 flips. If the number is higher than the number you bet on then you win. If it’s lower then you lose. If it’s the same then no money changes hands.
A few things to note. First, we’ll assume a “fair” coin, which means it’s equally likely to land on heads or tails. Second, since you’re equally likely to flip a heads or a tails, the most likely result from 10 coin flips is that the marker ends up on the same number it started on (this requires 5 heads and 5 tails). You can think about the possible outcomes as being a bell curve – the larger the number change the less likely it is to happen (moving from a 1 to a 9 requires 9 heads and 1 tail, with the last coin flip being a heads).
You decide to play the game. You walk up to the table and the dealer flips the coin 10 times, eventually landing on the number 5 (we know that this is the most likely result). Should you place a bet on number 5? Well, there’s no reason to, there are 4 possible higher numbers (6-9) and 4 possible lower numbers (1-4). You have as much chance of winning money as you do of losing money. Why bother?
The dealer starts the next round and ends up on a 3. Should you place a bet? The answer is clearly yes, as 10 more coin flips are much more likely to end up at a higher number than a lower number. You don’t need to guess what the number is going to be after 10 coin flips. You don’t have to do a statistical analysis to know that you have better than even odds of winning when the starting number is 3.
Now the dealer starts the final round and ends up on an 8. Would you place a bet? Of course not! The only way you can win is if the final number is 9. You tie on an 8 and lose on anything between 1-7. Yes, it’s certainly possible to win. No, there’s no way to say for sure what the final result will be, but you know that the odds are in your favor when the starting number is low and the odds are against you when the starting number is high.
It seems pretty obvious that the lower the starting number the better your chances of winning and the bigger your bet should be. If the starting number is a 1 you should literally bet everything you can – the house, the car, your children, etc. The worst case scenario is that you end with a 1 and you have a tie. Any other number is a win. Again, we don’t need to know the exact number that we are going to end up on to win.
And if the starting number is a high number you should stay away. We only want to play when the odds are in our favor, right?
I used the example above to get you thinking about trading in ranges. We have no idea what the next flip of the coin will result in, but we know that when you buy at the bottom of the range you put the long-term odds in your favor. When you buy at the top of the range the odds are against you. The same rule applies to the valuation of stocks and the market in general.
Although stock prices don’t trade in a range, valuations do. As I’ve mentioned before, I like using the CAPE (Cyclically Adjusted PE, also known as the Schiller PE) instead of the standard PE, as I think it does a better job smoothing out short-term price and earnings fluctuations. Here’s the CAPE for the last 100+ years:
It’s clear that over the last ~130 years, the market has traded in a band. Here are some historical valuations to compare to today’s valuation:
Now let’s look at the graph of the CAPE above. A few things jump out at me:
- It’s pretty obvious that the current valuation is well above the average. From 1880 to 1930 (50 years) the market’s valuation was never higher than the current valuation. Ditto from about 1935 to 1995 (60 years!).
- There have only been a few times when the valuation has been this high – right before the Great Depression, right before the DotCom era boom and bust, and right before the Global Financial Crisis/Great Recession.
- Sometimes in the past when the market hit these levels of valuation (for example, in the late 1990’s), the valuation continued to climb. Ditto with the few years before the Great Depression – the market valuation continued to rise for a bit longer before eventually blowing up. However, and this is key – it ALWAYS blew up.
We are clearly at the higher end of the historical valuation range. Yes, the market can continue to rise from here. When the valuation was at this level in the 1990’s the market continued to rise for about 3 more years before finally correcting. Valuation doesn’t tell us everything.
But here’s the thing – do you want to take the risk of investing today at these valuations? Investing today clearly puts the odds against you. In the game above, this would be like betting on an 8. Yes, there’s a chance that you could still win, but it’s not a smart bet.
Valuation vs. prices
So far we’ve said nothing about the actual price of the market. We’ve only been talking about valuation metrics.
In order to return to the long-term normal valuation of 16.7, the market will need to drop by almost 40% (assuming profits don’t change). However, that’s not the only potential outcome. It’s also possible that profits could increase by enough to enough to counteract the decrease in valuation. It’s also possible that rather than crashing, the market could maintain the current price for years, allowing profits to grow and thereby allowing the valuation to slowly creep down until the market is at its long-term average valuation.
But let’s look at that graph again:
When has the valuation EVER been at or above the current valuation and then slowly decreased over a number of years ? I’ll tell you when – never. That’s just not how investor psychology works. Every time the market has been valued this highly the correction is always swift and brutal on the downside.
It’s a market of stocks, not a stock market
As one of my favorite writers Chuck Carnevale likes to say, it’s a market of stocks, not a stock market. That is, just because overall market is overvalued doesn’t mean all of the individual stocks that make up the market are overvalued. Perhaps there are some great companies out there that are priced so that they offer compelling valuations today.
But the reality is that in a downturn the baby gets thrown out with the bath water. Even good, moderately valued stocks will be hurt by a general market downturn. Yes, you’ll probably do ok if you’re able to find a really solid, high quality, deeply discounted stock to buy now. If you DO find a stock like that, please do me a favor and email me immediately, because I don’t see anything like that when I do my research today. The stocks I’m interested in (Dividend Aristocrats and Dividend Champions) are trading around or above a P/E of 20, and the high quality high growth dividend stocks (Nike, Starbucks, Costco, Visa, etc.) are at P/E of 25+.
There are a few stocks I have my eye on, as I think they are getting close to offering sufficient valuation to be worth purchasing, even in the general environment we are in of overvaluation. These stocks include Wells Fargo (hammered by the recent scandal), Target, and some of the oil super majors (Chevron and Exxon).
So what do we do now?
So if the stock market is overvalued and bonds are at all time lows (see my recent post called Run away from bonds as fast as you can) what should you do with your money?
That’s right. You don’t have to do anything with it. Just stash it away in something liquid and safe. Maybe that’s a savings account. Maybe it’s a 3 month CD. The key is to build cash and have it ready to deploy when there are actually compelling values available.
I’m surprised when I see people writing about relative bargains in the market. They say things like “this stock is a bargain compared to the rest of the market”. That stance only makes sense if you are forced to buy something every week or every month – you have to do something, so find the best bargain you can.
But the great thing about investing is that you don’t HAVE to do anything with your money. As Warren Buffett once said, “The stock market is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!'”
Why would you force yourself to invest today when the market valuation is so high and the odds are clearly against you? Why not wait for a fat pitch? Wait until there are great values available and start aggressively buying great companies!
This doesn’t mean predicting the future. This doesn’t mean timing the market. This just means waiting until there are great companies available at discounts to their valuation.
The hardest part of investing is sometimes doing absolutely nothing for a long, long time (years and years in some cases). Eventually the market will swing the other way and something will be available for cheap. Maybe that will be stocks. Maybe it will be bonds, or real estate, or something else.
Sitting around and watching other people collect dividends or interest while your money is doing nothing is tough, but not as tough as having bargains suddenly available and you find you’re unable to capitalize because you don’t have any cash available.
The key is to wait for that fat pitch.
What are you doing with your money?