“Timing the Market” Using Stock Valuations

We live in interesting times. The stock market served up two brutal bear markets in one decade. I’ve even heard my relatives use the term “market volatility,” which is weird because normally I’m the most boring person in the room. Oh, and as of the end of 2011, bonds have outperformed stocks for 30 years.

Wouldn’t it be great if there were a signal, preferably a glowing bull or bear shining in the night sky, telling you when to get into the stock market and when to take your money and run?

According to two recent academic papers, there is such a (non-celestial, sadly) signal and over the past 100 years, investors who paid attention to it would have enjoyed better returns with less risk. Will it work for you and me? Pretty please?

Stocks: Expensive or cheap?

Both papers, one by Wade Pfau and the other by Michael Kitces and his colleagues, use a similar approach: Own more stocks when they’re cheap and own fewer when they’re expensive.

“Great advice, genius,” you say. “How do we know when they’re cheap or expensive?” By using the PE5 or PE10 ratio, which I am not going to explain, except to say that it compares the recent earnings of the company to the price of its stock. A measure like PE10 is called a valuation metric.

We can look at the ratio for an individual company or for the stock market, as a whole. If the ratio is much higher than the historical average, prices are high. In late 1999, for example, at the height of the Internet bubble, the ratio hit its all-time high. You can check the current and historical PE10 numbers for the S&P 500 here.

Kitces, director of research for Pinnacle Advisory Group, looked at what would happen if you started with a 50/50 portfolio (half stocks, half bonds). You bump up the stocks to, say, 70% when the PE ratio is exceptionally low (low is good, remember) and down to 30% when it’s exceptionally high. Among my colleagues, “market timing” is a curse word that brings to mind a feverish day-trader earning huge commissions while losing money. That’s not what Kitces or Pfau are talking about. “This is not exactly a rapid cycling system here,” says Kitces. “You’re talking about a system that gives an overweight or underweight recommendation, on average, twice a decade.”

The result: Over the long term, the strategy added up to half a percentage point in returns, while reducing downside risk. Sounds good, right? I wish I had gotten a signal to own more bonds and fewer stocks in 2008-09. Unfortunately, we can still wear 80s outfits, but we can’t get back 80s stock returns. Sure, Kitces found a strategy that would have worked in the past, but do we have any reason to believe it’ll work in the future?

“We all use past performance to understand stock returns,” says Kitces. “If you don’t believe our numbers hold water because the future could turn out to be different from the past, it undermines the entire reason for even owning stocks in the first place.” That is, if you believe stocks are going to return something like 10% a year, on average, because that’s what stocks have done for the past 100 years. Let he who is without hindsight bias cast the first stone.

Bad behavior

Let’s assume for the moment that Kitces and Pfau have genuinely identified a way to beat the market over the long term. What will happen if you adopt their strategy with your own portfolio?

You’ll spend a considerable amount of time feeling like an idiot. “It’s going to tell you to not buy stocks in the late 1990s, when everybody bought stocks,” says Kitces. “It’s going to tell you not to buy stocks when everybody else is screaming at you to buy stocks. This system would have been telling you to get out of stocks in 96 or 97, which means you would have looked like a moron for almost three years.”

It’ll also tell you to buy stocks in 1981, when Business Week proclaimed “The Death of Equities.” It’s hard enough to stay the course when you’re losing money along with everyone else. Pursuing a contrarian strategy is even harder. As Pfau put it, “Implementing these strategies requires strong nerves to maintain a contrarian strategy that may only pay off in the long term.”

Meir Statman, professor of finance at Santa Clara University and author of What Investors Really Want, wrote an earlier paper on this type of market timing and concluded it wasn’t worth the trouble. “In my view, individual investors are not likely to benefit from it,” he told me via email. “The amount of information is small, contaminated further by hindsight errors. Execution is costly in taxes and, more importantly, in psychological costs.”

Shutting down inefficiencies

Mike Piper, who writes the Oblivious Investor, points out that while the idea of investing based on stock market valuation is very old, the ability to carry out the kind of strategy proposed by Kitces and Pfau isn’t. Prior to the mid-70s, he points out, there weren’t any no-load index funds for investing in the broad stock market, and transaction costs (including taxes) were much higher.

“If a backtest ignores actual historical circumstances, then it’s not going to be particularly meaningful as a way to prove the existence of a particular market inefficiency,” he explained via email. “Inefficiencies don’t get eliminated until somebody decides to try to profit from them.”

Put another way, it’s now cheap and easy to invest in the entire stock or bond market inside a tax-advantaged account, like an IRA or 401(k). Nearly anyone who wants to follow a valuation-based timing strategy can now do so from the comfort of their desk chair without paying a dime. Once that happens, the strategy won’t work anymore.

Another way to get there

Okay, wait a minute. Enough of the technical blather. If you’re a stock market investor and participate in a massive 80s-style bull market or 2000s bear market, you’ll be highly conscious of one particular indicator: Your account balance.

Real-world investors, not hypothetical folks from academic papers, invest to achieve goals. Let’s say you’ve just come through a massive bull market. “Not only has the future expected return gone down, but you have less need to take risk, because you got a higher than expected return,” says Larry Swedroe, director of research at Buckingham Asset Management and author most recently of Investment Mistakes Even Smart Investors Make. “It’s like an inheritance. You should be much closer to your goal. So, what you should do is change your asset allocation to reflect not a market-timing decision, but the fact that one of the assumptions now has changed: Your need to take risk has changed because of the bull market.”

Swedroe agrees that valuation measures are important, but determining your goals and your need and ability to take risk comes first. You look at how much you need for retirement, how much you can afford to save, and what asset allocation might get you there. Then, you might look at a valuation measure to see if expected stock returns are historically out of whack. At that point, you can decide to take more or less stock market risk or do something boring, like work longer or spend less.

“An investment plan should be a living document, not a plan that lives forever,” says Swedroe, “and you should change it anytime any of the assumptions change, including the need to take risk because the market has changed.”

Words from the scriptures

Still, though, valuation-based market timing intrigues me. Why should I buy stocks no matter what the price? Whenever a siren song calls to me, I turn to the bible of modern investing, A Random Walk Down Wall Street by Burton Malkiel, for guidance. (You can find justification for almost anything in Random Walk, so bear with me.)

Like everyone else, Malkiel agrees that valuations are important and may even have some long-term predictive value. However:

[T]he same models that identified a bubble in early 2000 also identified a vastly “overpriced” stock marketin 1992, when low dividend yields and high price-earnings multiples suggested that long-run equity returns would be close to zero in the United States. In fact, from 1992 through 2004, annual stock market returns were over 11 percent, well above their historical average.

Uh-oh.

In December of 1996, when Chairman Greenspan gave his “irrational exuberance” speech, those same models predicted negative long-run equity returns. From the date of the chairman’s speech through December 2009,the stock market returned 7 percent per year, even after withstanding two sharp bear markets.

Double uh-oh.

Here’s what it comes down to, for me. I suspect Pfau and Kitces are onto something. If so, however, I suspect their approach will be less profitable in the future than it has been in the past, for the reasons Mike Piper laid out. Furthermore, I doubt I could handle the stress of following a contrarian strategy, especially the part where you jack up your stock allocation and stocks continue to decline for several years.

That being said, I’m sticking with with buy, hold, and rebalance. This is both boring and wimpy, but it doesn’t matter whether I beat someone else’s portfolio, only whether I achieve my own personal goals. Oh, and if you’re beating my portfolio, I don’t want to hear about it.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.