There is an adage from Wall Street’s early days: “Valuation helps define risk, but it doesn’t help with timing.” Brokers learned eons ago that simply because a stock is cheap or expensive says nothing about its short-term price direction.
Modern finance has a variation of this saying: “Valuation helps define long-term expected asset class returns, but it sheds very little light on short-term returns.”
A study by Vanguard Group Inc. analyzed the capability of 16 metrics, including the trailing price/earnings (P/E) ratio and the cyclically adjusted P/E (CAPE) ratio (the latter was developed by Yale University’s professor Robert Shiller to predict real stock returns for the year ahead.) Based on U.S. data from 1926-2011, the Vanguard study concluded that short-term stock returns are fundamentally unpredictable.
The best metric a combination of dividend yield and real earnings growth explains only 12% of the variation in one-year stock returns. Trailing P/E and CAPE ratios cited in an endless stream of articles today warning of the perils of an overvalued stock market explain even less. An investor may as well use seasonal rainfall numbers for predicting short-term returns.
Professor Aswath Damodaran of New York University analyzed the returns generated using the CAPE as a market-timing metric for 1927-2016. He assumed a market-timer would move to cash out in any year in which the CAPE in the prior year was overpriced (defined as being first 25%, then 50% higher than the median CAPE of the previous 50 years). In both cases, a “buy and hold” investor’s cumulative returns far outpaced the market-timer’s.
Another study by academics used the price/dividend ratio as a metric for market-timing. Stocks were sold and an investor went to cash when this metric indicated stocks were expensive. Stocks were repurchased only when they became cheap. In all 20 countries in which this strategy was tested, an investor would have been better off just to buy and hold stocks.
A review of U.S. market history supports the view that valuations cannot be used to time markets successfully, particularly given the behavioural challenges in being out of rising markets. Try shifting into cash in February 1996, a point in history during which the CAPE had surged to more than 25 more than twothirds higher than its long-term average of 15. The market ran up by almost 130% over the next four years and seven months before peaking. For an investor sitting in cash on the sidelines, this period would have felt like eternity.
How about exiting the market in January 2004, when the CAPE hit 27.6? Despite high valuations, the market pushed upward over the next three years and nine months, earning a cumulative return of more than 45% before peaking.
More recently, Shiller commented that the U.S. stock market was pricey as early as 2013. In fact, he wrote an article in August 2014 stating the market was very expensive. Since then, the U.S. market has generated cumulative returns of almost 25% (for Canadian investors, about 52% due to the drop in the loonie).
Instead of trying to time the market, you can truly assist your clients by building sound investment plans that recognize the low, long-term returns available in the capital markets today, then systematically rebalancing as stock prices oscillate throughout the inevitable market cycles.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment counselling firm.
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