Why Market Timing Doesn't Really Exist

by: Cory Cramer
Summary

Beware of investment writers who use 'market timing' as a bogeyman with which to contrast their losing ideas.

For most intents and purposes, almost nobody is a real 'market timer'.

This article breaks down what people might really mean when they talk about 'market timing' and it examines what it is they are really referring to.

I argue that so-called 'market timing' is really sentiment gauging, and that even if one avoids sentiment gauging that doesn't mean they automatically become a buy-and-hold investor.

Source

Introduction

If there is one thing I've learned from reading Seeking Alpha over the years it is that almost nobody wants to be labeled a "Market Timer". In fact, at this point, I'm not sure there has ever been a bigger investing strawman in the history of the universe than 'Mr. Market Timer'. It seems that whatever illogical or poorly made decision an investor wants to justify, as long as they can point out that they were not "timing the market", the bad investment can be dismissed, understood, or forgiven.

'Sure, I suggested buying this stock over and over again for the past 4 years and it has done nothing but go down during this time', they say. 'But I'm not a market timer, so it's okay. Because, you know, it's those stupid 'market timers' who sold me this wonderful stock 4 years ago when it was dramatically overvalued who are the bad guys here. Not me. I plan to hold for the long term. So therefore, my money-losing decision is correct.'

Okay, that's not a real quote, but it's more true than most quotes you'll read.

I could write a book on this topic, but today I just want to make the point of one very important thing: For most intents and purposes, true market timing doesn't exist. So, claiming that you are not a market timer is a meaningless statement. And whenever you read someone who claims not to be a market timer as part of a defense of a losing investment, you should run the other way from that person as fast as possible.

Now, this doesn't mean that one can't deny being a 'market timer' or explain why they are not 'timing the market' in response to someone making that claim. I get accused of being a market timer all the time. And since market timing doesn't really exist, I clearly can't be one. So, what I am referring to here is when someone references 'market timing' as if it is a real thing. And particularly when they reference it as if it was a real thing in opposition to their particular investment strategy as a way to justify that strategy. Those people are dangerous. Those people will lose you money. And those are people you should distance yourself from.

Mr. Market Timer: Our Invisible Friend

Let's being by imagining Mr. Market Timer as he is often alluded to. I use the word 'alluded' because we rarely get more than a mystical sketch of what market timing actually is. Mr. Market Timer is made out to be the person who "times" a market top and/or "times" a market bottom, hence the two words "market timer". This implies that there is a certain amount of time that the market can go up before it peaks, and a certain time that it can go down before it bottoms, and that a good "market timer" can figure out those times and go in and out of the market based on some length of time between market cycles.

It's the equivalent of timing a jump. Imagine you are running down a path and trying to jump over a stream without getting wet while wearing a blindfold, and you're running at a certain rate (the equivalent of the market's rise in price) if you know the number of steps between your starting point and the edge of the stream then you can time your jump so that you can take off close enough to the stream's edge to make it to the other side without getting wet. This is basically the sort of activity or skill that is being referred to with the term market timing. A person says, hey, the market has been rising at such-and-such rate for such-and-such time, now it's time to sell while the market is high before the market falls. There is only one problem with referring to people who do this as "market timers".

They don't exist.

Oh, sure, sometimes there will be references that it has been a long bull run for the market (the longest in history) but this is almost always a reference that investors should be cautious and diligent after that sort of rise in price, not that we have crossed some special time threshold since the last recession, we are now near the top of the market because we have crossed that time threshold, and selling stocks is now the only reasonable thing to do. I don't think I've ever read or heard a single writer or commentator claim that because a certain about of time has passed, it's now time to buy or sell. Market timing of this sort simply does not exist in any practical sense, so when someone claims that they are not doing it, it doesn't say much about them or their investment process at all. It's the equivalent of saying "I'm not a booger eater." So what. Almost nobody of any importance is.

What people really mean when they say 'market timing'

I think at this point in my argument it would be fair to say that I have created a strawman of my own. The truth is, probably when people refer to market timing they mean something different than actual "market timing". So, I'm going to be generous here and share what it is I think they really mean when they say market timing. I think what they really mean is sentiment gauging. And that what they are saying when they claim not to be market timers is that they are not sentiment gaugers. This means that when they go to buy or sell a stock they do not take into account the market's feelings about the stock.

Let's try to take a clear-cut case of a business whose stock trades at a 15 P/E ratio and will only grow earnings at the rate of inflation forever. So, we have effectively taken the holding period, earnings growth, and inflation out of the equation. Let's also say the business has no debt and pays all their earnings out in dividends, so they have 6.67% dividend yield. If all these things are true, a person could buy the stock of this company and get a 6.67% inflation-adjusted return forever. If we assume that is a satisfactory return, a person could buy this stock and completely ignore the market price forever, thereby avoiding gauging market sentiment either historically or in the future. If you are one of these people, congratulations, you have avoided gauging market sentiment, and therefore you are not a market timer.

Now let's say a time comes in the future when everything above is still true, but the stock price has risen relative to earnings such that the P/E ratio is now 45. The person who invested at a 15 P/E is now being offered triple what they paid for the business by the market. The non-market-timer/non-sentiment-gauger will, of course, reject that offer. They don't care how much someone offers, this business is bulletproof forever and they will never sell at any price, no matter how ridiculously high the sum.

Folks like me are different, however, and I break out the calculator and history book when someone is offering what appears to be a high price. Let's start with the calculator. At a 45 P/E, all else being equal, the potential buyer at that price is willing to pay me for about 17 years worth of earnings upfront plus my original investment back. Assuming I can find a better investment to put the money in, then I can still sell using that justification without any sort of sentiment gauging. This is an important distinction investors should note. The principle of avoiding gauging sentiment/market timing and the principle of buying-and-holding forever are two separate principles. One can sell a stock simply because they can take the money they had invested in it and immediately start earning more with that money in some other investment. And one can do this while avoiding market timing or sentiment gauging altogether. So, selling the stock of a highly-priced, quality business on its own does not make one a 'market timer'.

It's when we open the history book and look at historical sentiment patterns that we might legitimately be called sentiment gaugers. I call this "sentiment mean-reversion" in my analysis, and when I perform analysis on stocks whose earnings are reasonably stable over long periods of time, I separate out the sentiment mean-reversion expectations from the actual earnings expectations of the business, precisely so investors can see where future returns are likely to come from. Personally, I care about both. If the market has a history of changing how it feels about a stock I think it's reasonable to take that into account so long as nothing has drastically changed with business.

For example, take the same business I noted above. If the business has been pretty much the same over the past several decades but sometimes it has traded at a P/E of 10 and sometimes as high as a P/E of 45, but most of the time it has averaged a P/E 15, I think it's reasonable to take profits when the P/E is very high, and to try to buy the stock when the P/E is 15 or under because the market has a tendency to revert to the mean. Sentiment changes for various reasons, and often those reasons tend to repeat themselves in one form or another throughout time. Read enough history and you'll start to see these patterns. Since I use this as part of my investment process and base a part of future stock price expectations on this sort of the change in sentiment and reversion to the mean, part of my analysis in colloquial terms, generously interpreted, might make me a "market timer", even though market timers don't really exist.

Summing Things Up

Assuming what people really mean when they call someone a "market timer" is that they are "sentiment gaugers", then any investors who uses a reversion to the mean assumption as part of their future return expectation is a "market timer", because they assume that over time the sentiment for the stock will change and likely revert toward the mean once other factors are taken into account.

It is important to note that sentiment expressed in the form of a P/E ratio for steady-earning stocks is also directly tied to the returns from the business one will get (the lower the price you pay the more earnings you get from the business). So market sentiment is almost never completely detached from analyzing the returns of the business. As long as we are talking about individual stocks, sentiment is measured in terms of price to earnings, sales or free-cash-flow, etc. It's only when an expectation of returns using reversion to sentiment mean is taken into account when one becomes a "sentiment gauger".

I try to write my individual stock analyses in such a way so that readers can separate the sentiment expectations from earnings expectations. I use one category of expected 10-year returns that is likely to come from sentiment-mean-reversion and another category that comes strictly from the earnings yield and earnings growth. This way, different types of investors can still potentially find the analysis useful, all they have to do is ignore the sentiment-mean-reversion estimate if they don't care about it.

What I don't do is imply that my stock analysis is correct when after I buy a stock the price goes down, and then try to justify my mistake by claiming that I'm not "market timer", as if avoiding paying attention to sentiment and claiming to be a "long-term investor" somehow shields a person from making bad investments. It doesn't. But what I find disturbing is that some of these same investors who shun the Mr. Market Timer strawman when their investments have lost money for multiple years in a row will also simultaneously claim credit for their successful ideas based on, you guessed it, changes in market sentiment. So, when the market sentiment works in their favor and the price of one of their ideas goes up, that's great, forget the fact that they are gauging sentiment (aka timing the market) but when sentiment works against them, now they are 'long-term investors' and only those dreaded 'market timers' would pay any attention to that downward price movement based on sentiment.

I get it. Swings in market sentiment are difficult to deal with as an investor. As are mistakes. But you can't have it both ways. You don't get to be a sentiment gauger when prices rise on a successful investment, and then shun market timing when prices go down.

Conclusion

This article mostly focused on the "timing" part of so-called "market timing". I intend to write about the "market" part in a future article as well, since both terms are misleading. In the meantime, if you would like to learn more about gauging the sentiment of individual stocks and some of the dangers of sentiment cycles. Consider reading a new series of articles I've been working on that explores how do deal with these swings in market sentiment. You can read about the strategy in these three articles: Part 1 "Ignore Sentiment Cycles At Your Own Risk," Part 2 "Mitigating Sentiment Cycles" and Part 3 "Sentiment Cycles: When To Sell And When To Buy Back Again."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.