Sunday, December 16, 2012

Is Market Timing a Loser's Proposition?

François Rochon, the head of wealth-management firm Giverny Capital, writes, Timing the stock market really is a loser's proposition:
Many years ago, filmmaker Woody Allen said "80 per cent of success in life is showing up." And so far he has lived up to his standards: for more than 40 years, he's been making a new movie every year.

I think this notion applies to the stock market as well: To earn the return of stocks - on average around 10 per cent per year - you first and foremost have to be invested in stocks.

My favourite annual reading (besides Warren Buffett's letter to his shareholders) is the Dalbar research on investors' behaviour. Let's go through the results as of 2011.

First, the average equity mutual fund retention rate over the past 20 years has been 3.29 years. Dalbar concludes: "One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets."

Now if investors are not holding their equity investments for long periods of time, it is probably because they believe they can "time" their buy and sell decisions wisely.

Dalbar shows in its study that "data further underscores the fact that investors fail at timing the market." Last year was a disaster for equity investors: The average investor lost 5.73 per cent in 2011 compared with a gain of 2.12 per cent for the S&P 500.

This is far from a one-year anomaly. Over the past 20 years, the average equity investor earned 3.49 per cent annually, compared with 7.81 per cent for the S&P 500. This 4.32 point difference is mostly linked to investors not having a long-term outlook.

They juggle their portfolio between stocks and bonds with few rewards. If they had simply stayed invested over those 20 years, they could have doubled their return. For investors, success really would be to stay invested instead of trying to "time" their entries and exits.

The professional (or institutional) investor is not immune to the psychological tendencies of trying to time the stock market. Like individual investors, they rarely can time their asset allocation decisions properly.

For example, I know a great money manager who has a 13.3 per cent annual return over many decades. This is an outstanding track record. Would you believe the stocks he owned have actually returned 15.8 per cent per year? But by holding lots of cash (on average, something like 20 per cent of assets), his annual return has been reduced by 2.5 per cent on average.

I never understood this. For me, it's quite simple: if stocks return 10 per cent a year over the long run, bonds return five per cent and cash returns three per cent, why on earth would you not be 100 per cent invested in stocks?

Ah ... but we hear all the time that we need diversification; we need a balanced portfolio; we need to hold cash for when the market goes down. These sayings are long on tradition but short on wisdom. If you can't sleep at night with a 100 per cent stock portfolio, I agree that holding fixed income securities makes sense (what's the point of being rich, if you don't sleep at night?). But for the sake of this article, let's put emotional reasons on the side and focus on purely financial parameters.

If holding stocks is far more rewarding than holding bonds and cash, why buy anything else than stocks? Moreover, if investors - individual and institutional - have proved time and time again that they can't predict when to buy and sell stocks, why even try?

That is why, 20 years ago, when I started to invest in the stock market, I decided I would always be invested in stocks and that I would spend no time trying to predict market fluctuations. I've focused all my efforts in finding the best companies to own for our portfolios and it's worked out pretty well.
While I agree that timing the market is a losing proposition, the truth is the next 20 years won't look anything like the past 20 years. Just look at your starting point. Historic low interest rates and a long debt and deleveraging cycle means we will see low returns and a lot more volatility in public markets (bonds and stocks).

Given low returns and increase in volatility, global pension funds have taken a long-term view, shifting assets out of public markets into private markets (real estate, private equity, and infrastructure). And while some investors are rethinking their hedge fund stakes, the hunt for yield is intense, pushing investors back into structured credit and other absolute return strategies that aren't correlated to traditional stocks and bonds.

On Friday, I wrote on hedge funds born to run, explaining why many hedge funds are struggling in this low rate environment dominated by macro news and central bank interventions. I also went over 13 important trading tips from hedge fund legend Paul Tudor Jones:
1. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

2. I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over.

3. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you?

4. These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates an illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust price action. The pain of gain is just too overwhelming to bear.

5. There is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it.

6. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.

7. That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?’

8. If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.

9. Losers average down losers

10. The concept of paying one-hundred-and-something times earnings for any company for me is just anathema. Having said that, at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?

11. The normal progression of most traders that I’ve seen is that the older they get something happens. Sometimes they get more successful and therefore they take less risk. That’s something that as a company we literally sit and work with. That’s certainly something that I’ve had to come to grips with in particular over the past 12 to 18 months. You have to actively manage against your natural tendency to become more conservative. You do that because all of a sudden you become successful and don’t want to lose what you have and/or in my case you get married and have children and naturally, consciously or subconsciously, you become more conservative.

12. I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

13. I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.
These are all great tips, but let me give you a few more to prepare you for what lies ahead. As you know, I ignored all the distractions this year, including Grexit, the imminent collapse of eurozone, the hard landing in China and the US fiscal cliff. I prefer focusing on price action and what top funds are actually buying and selling.

I've also warned my readers never to follow top funds or any other money manager blindly. I was at a dinner party last night, discussing trading ideas with one doctor who likes investing in stocks. A buddy of mine, a broker, was teasing me: "Don't listen to Leo, short all his ideas."

He reminded me that the solar boom I was waiting for turned out to be a disaster. True, solar stocks, especially Chinese solar stocks, got decimated in 2012. Some like Trina Solar (TSL) are making a comeback from penny stock levels but the leader in this sector remains First Solar (FSLR), an American company which is a favorite of many top hedge funds.

But even though I like solars, I always warned my readers these are extremely volatile stocks. In the past six months, been accumulating coal stocks because I like the price action and think they will run-up considerably in the first half of 2013 as China's economy picks up strength.

What else did we talk about last night? Apple's slide, of course. I told the doctor to look at price action before Apple announces earnings in late January. "If you see it going up prior to earnings, buy but there is no rush. In fact, it might be better to wait till after earnings, especially if the shares keep sliding." I also told him that while Apple still has the leadership and "Apple community," there is intense competition in smartphone and tablet market.

Then we got talking bout Research in Motion. My buddy, the broker, kept razzing me about betting on BlackBerry's revival last January when stock was at $16. It fell to a low of $6.22 in September. I told him to read my comment again:
Although I do not own RIM shares right now, the share price is attractive at these levels and on my radar. If the company is able to boost market share successfully launch Blackberry 10, RIM will rebound and thrive. And although I love my iPad and iPod, I will never give up my BlackBerry (but the Torch disappointed me, stick to the Bold).
I never bought RIM but still love my BlackBerry Bold and absolutely hate the Apple iPhone. I am used to my BlackBerry, like the keyboard and think the new smartphones are too big, too heavy and full of Apps and gadgets I don't need. All my friends still bug me about my Backberry but I couldn't care less.

And it so happens RIM's stock (RIMM) has rallied sharply from lows as optimism is building. The stock closed above $14 on Friday but I think traders will take profits once the announcement is made of their new product. The point is, don't count RIM out just yet. Same goes for Nokia (NOK), another global cellphone company whose shares got pummeled but have rallied sharply since September as investors await launch of new products.

My buddy blasted me on for telling him to sell his Canadian banks last year. "Thank God I didn't listen to you!".  Told him Canadian banks had an impressive run but I'm much more comfortable with US banks right now. I bought JP Morgan after the London Whale fiasco in the low 30s and recently sold it at $42 to realize on my gains and invest elsewhere (still long US banks; keep an eye on Bank of America).

The sectors I like most right now are copper, coal, and steel, basically all sectors that are leveraged to China and global growth. I trade and invest in companies like Arch Coal (ACI), Alpha Natural Resources (ANR), Peabody Energy (BTU), Walter Energy (WLT), Freeport-McMoran  (FCX), Nucor (NUE) and US Steel (X). Also like Cliff Resources (CLF) but possible cut in its dividend makes it a riskier bet.

We also talked about dividend stocks. The doctor told me he likes Manitoba Telecom Services (MTB.TO) because it pays a 10% dividend and stock price is stable. Told him don't know enough about them but to look at Fortis (FTS.TO) and insurance companies like Manulife (MFC) and Sunlife (SLF). We also briefly talked about oil, commodity prices and pipeline companies like TransCanada (TRP) and Enbridge (ENB) (be careful as pipeline stocks have enjoyed huge run-ups).

All this to tell you that while market timing is exceedingly difficult, if not impossible, in this environment, you always have to think about your portfolio and make adjustments as opportunities arise in sectors and specific stocks. Then again, those that bought great companies like Home Depot (HD) years ago and forgot about them, made off like bandits!

Below, Bloomberg Businessweek Economics Editor Peter Coy and Guggenheim Partners' Scott Minerd discuss the impact of recent economic data on the U.S. stock market. They speak with Pimm Fox on Bloomberg Television's "Market Makers."

And in a recent interview with Forbes, AQR Capital Management co-founder Cliff Asness explained why not everything hedge funds (or any asset managers) offer are worth premium fees (watch it here).