Timing the Market with Past Returns?

Best of Luck

Professor Matthew Spiegel

July 19, 2005

Updated: September 27, 2005

After celebrity gossip America’s favorite topic of discussion has to be whether or not the stock market is over or undervalued. With good reason too; unlike most conversational topics this one can actually change how well you live. Everybody wants in right before a big rally and out before a fall. But wanting and getting are two different things. Is there some way to time the market? Listening to the “experts” it must be easy. Every day there are numerous articles, and television pundits telling investors whether it is time to get in or out. Of course, the problem seems to be that they typically offer opposite directives. A July 16, 2005 Houston Chronicle article by Associated Press writer Ellen Simon titled, “Market Values Which is Right” exemplifies the problem. Quoting from her article:

"Wake up, equity market! I recommend 100 percent stocks," Edward Keon, chief investment strategist and director of quantitative research at Prudential Equity Group, wrote in a research report, arguing stocks look "very cheap" compared with bonds.

Not so, says James Stack, president of InvesTech Research in Whitefish, Mont. "From a historical perspective, stocks are approximately 20 percent overvalued."

Well that certainly is problematic. Who should you listen to?

At this point some common sense can go a long way. Imagine stocks are clearly overvalued, what would you and everybody else on the planet do? Why sell of course. But to who? After all everybody is selling. Only one thing can happen in a case like this, prices have to fall. Then fall they will. Until, that is, the market’s consensus brakes down. Those holding shares of stock cannot (obviously) believe they are overvalued. A similar scenario plays out if stocks are clearly undervalued. In this case every investor will attempt to buy shares, driving up their price, until once again the market’s consensus brakes. Basically, if you can easily determine if the time is right to buy or sell stock prices will move until you are no longer so sure.

Neither a Contrarian nor Trend Follower Be

Contrarian investors believe the market overreacts to news causing wild swings that are later on corrected. According to this view of the world the time to buy is right after the market has declined significantly, and the time to sell is right after a substantial rise. Trend followers (also called momentum investors) hold the opposite beliefs. These individuals believe that once stocks begin moving in one direction or the other they then continue to do so for an extended period of time. A momentum investor sells stocks once they start to decline and buys them once they begin moving up.

So are the contrarian or are the momentum investors right? As far as the overall market goes the answer appears to be neither. This is actually quite easy to see by simply looking at historical returns. Begin by taking the market’s annual return and then subtracting the return from investing in one month treasury bills (the risk free asset) during the same year. In the graph each point represents this “excess return” in some year (t) minus on the horizontal axis paired with the corresponding return in the following year. For example, in 1992 stocks returned 5.7% than short term treasury bonds and in 1993 they returned 8.7% more. This is represented on the graph with a dot above 0.057 along the horizontal axis, and across from 0.087 on the vertical axis.

If the contrarians are right the dots should more or less point downward. High returns in one year (t) should be followed by low returns the next year (t+1). If the momentum investors are right then the dots should point upward. In this case high returns should follow high returns, and low returns should follow low returns. But, as the graph shows, there is no apparent pattern. For those of you that know what a correlation coefficient is it is a lowly 0.036. This number is scaled between -1 and +1 with a value of zero indicating no relationship. In the real world, 0.036 is about as close as one can get to finding absolutely no pattern.

Maybe you think a year is too long? Perhaps high returns in one month can be used to predict high returns in the next month? With monthly data it is somewhat difficult to distinguish the individual dots but then again, why bother? The cloud of dots once again produces a pattern that points neither up nor down. It seems clear that using one month’s return to predict returns in the next month has yet to yield consistent profits in the U.S. stock market.

The Value of Not Timing the Market

The ultimate difficulty with trying to time the market is that just being “good” may not be good enough. Since 1927 in an average year the stock market has returned 8.3% more than short term (risk free) government bonds. Yes, that is 8.3%! So here is the problem, suppose you are a “good” but not great market timer. When you think the market will have a bad year it does tend to have a lower than average return. But lower is not enough, it needs to be lower by 8.3% if you hope to actually earn a higher return in the bond market. Can you, or anybody else you know, predict when the market will have a return that is 8.3% below normal? My colleagues will now tell me, “Ah, but if the market return will be below normal you should reduce your stock holdings since the risk/return ratio is no longer as favorable.” Very true. If you believe the market will have a below normal return you should reduce your stock holdings. By how much will depend upon how strong your beliefs are. However, looking at the two graphs it seems hard to see why current stock returns should lead you to believe future returns will be either higher or lower than average. While tracking the market’s latest moves may be useful for parlor conversation it seems like a poor basis on which to determine what the market’s future will bring.