I am a big-time advocate of valuation-based market timing. In a world in which valuations affect long-term timing (the world we live in, according to Robert Shiller’s Nobel-prize-winning research), valuation-based market timing is critical. It is the means by which investors rein in irrational exuberance before it gets out of control and causes a price crash and an economic collapse.
Buy-and-Holders oppose market timing.
Strong case for valuation-based market timing
The case for valuation-based market timing is so strong that I sometimes wonder if Buy-and-Holders are not thinking of valuation-based market timing when they advance statements opposing market timing. In fact, there have been many cases in which I have seen a Buy-and-Hold oppose market timing and then describe the problems with the guessing-game approach to market timing to explain the opposition. The Buy-and-Holder might point out that, for market timing to work, the investor needs to be right re both his guesses as to when to lower his stock allocation and when to increase it. That is of course so for guessing-game market timing but not for valuation-based market timing.
Is it possible that the controversy is merely one of semantics and that Buy-and-Holders are just fine with investors changing their stock allocation for the purpose of keeping their risk profile constant at times when stock prices get out of hand?
I don’t think that that’s possible. If Buy-and-Holders appreciated the importance of investors practicing price discipline through valuation-based market timing, they would pay a good bit of attention to the CAPE level and work with investors to ensure that they never permit the CAPE level to rise to the level where it resides today. Buy-and-Holders have a long history of evidencing indifference to valuation increases, which strongly suggest that they just do not appreciate the importance of valuation-based market timing.
That said, I do believe that it was their opposition to guessing-game market timing that caused the Buy-and-Holders to oppose market timing in the first place. Shiller’s research had not been published at the time when Buy-and-Hold was being developed. So I believe that all that the Buy-and-Holders had in mind when they initially came out in opposition to market timing was the guessing-game approach. It was only when Shiller’s research was published in 1981 that those who follow the research became aware of how important it is that all investors practice valuation-based market timing (no market can remain functional if market participants refrain from exercising price discipline). By the time the research showing the realities was published, Buy-and-Holders had been finding fault with market timing in general for many years and a defensiveness that caused them to want to blur the distinction between the two forms of timing kicked in.
Valuation-based market timing is not guessing-game market timing. If Shiller is right that it is investor emotion that is the dominant cause of stock price shifts, there is no way that any investor could effectively predict when price shifts would take place – how could anyone predict a phenomenon not governed by rational considerations? So guessing-game market timing is out. But there is nothing even a tiny bit irrational about expecting prices to correct sooner or later once they get wildly out of whack. It is the core purpose of a market to set prices properly. So investors who change their stock allocation in response to big price swings can possess a high degree of confidence that prices will move in the expected direction at some point in the future.
So I don’t believe that the Buy-and-Hold opposition to valuation-based market timing is at all deep. Had Shiller’s Nobel-prize-winning research been published before the Buy-and-Hold strategy was developed in the 1960s, our Buy-and-Hold friends would all be practicing valuation-based market timing today. The trouble is that, once they took a public position that market timing in general is not needed or might not even work, they became reluctant to acknowledge the mistake. The fact that the mistake is undoubtedly the worst one ever made in the history of investment analysis (what could be worse than cutting off the possibility of price discipline for the entire market?) had made the process of getting the mistake acknowledged and corrected an exceedingly difficult one.
I believe that the Buy-and-Holders possess a sincere desire to follow research-based strategies. Once they see that their opposition to valuation-based market timing is not viable in a long-term sense (a continued reluctance on the part of investors to practice valuation-based market timing will eventually cause another price crash and economic collapse), they will happily retreat from their long-term opposition to the form of market timing that always works and is always 100 percent required for every investor seeking to keep his or her risk profile constant over time.
Rob’s bio is here.
