September 22, 2014

Market Timing Test ($ ?s)

$ ?s

Q: I have put my investments in bonds until this global economic crisis settles down and the economic woes of the European Union subside. Do you have any suggestions for indicators that I should look for to get back in?

Sincerely, Timing Tim

Dear Timing Tim,

Pulling out of the markets during unstable economic times is enticing. Why not simply sit on the sidelines until the investing climate appears more normal? Don’t fool yourself. Timing the markets is harder than it looks.

Consider the following historical global examples. What would you do?

1. United Kingdom LARGE CAP INDEX (1975): The world was in the middle of the worst recession since the 1930s. The London Stock Exchange had already lost 73% of its value during the crash. British gross domestic product (GDP) was still falling in 1975. Inflation was running rampant (and continued for several more years) all around the world. Do you pull out or invest?

2. S&P 500 (1938): The recovery from the Great Depression was sputtering. After finally regaining its value from the pre-Depression high, the S&P 500 dropped another 35% in 1937. GDP was falling, and unemployment was still above 15%. Do you pull out or invest?

3. NASDAQ (2001): The speculative dot.com bubble that started in approximately 1995 burst with a climax on March 10, 2000. The NASDAQ had already been down 38.8%. Do you pull out or invest?

4. U.S. SMALL CAP INDEX (2001): Same environment as above. With hindsight, you know that September 11, 2001, is approaching. Do you pull out or invest?

5. S&P 500 (1942): On December 8, 1941, President Franklin D. Roosevelt asked Congress to declare war on Japan following the Pearl Harbor attacks. The United States was about to enter a global conflict involving all of the world’s great powers. Do you pull out or invest?

6. JAPAN LARGE CAP INDEX (1991): There was a large asset bubble both in real estate and equities that peaked in 1989. In 1990, the index had crashed 36.1%. The Japanese government began bailouts, and banks kept injecting new funds into unprofitable companies to keep them afloat. Do you pull out or invest?

7. U.S. SMALL CAP INDEX (1991): The Federal Reserve had been raising interest rates from 1986 to 1989 to contain inflation. In addition, oil prices spiked in response to the first Gulf War, and U.S. GDP was falling. Do you pull out or invest?

ANSWER KEY: Stop reading if you haven’t answered all 7 questions.

1. Invest is the correct answer. In 1975, UK LARGE CAP INDEX returned 117.7%. Those who remained invested for the following 10 years averaged 22.6%, which was 15.6% better than bonds (as measured by the long-term U.S. government bond index).

2. Invest is the correct answer. In 1938, the S&P 500 returned 31.1% and returned 9.6% average annual returns for the following 10 years, which was 6% better than bonds.

3. Pull out is the correct answer. The NASDAQ COMPOSITE INDEX would fall another 20.1% in 2001 and 30.7% in 2002. The 10-year returns for the NASDAQ investor averaged 1.2%, which was 5.4% less than you would have earned in bonds.

4. Invest is the correct answer. The U.S. SMALL CAP INDEX returned 18% in 2001 and averaged 9.6% in bonds, which is 3% better than you would have received in bonds.

5. Invest is the correct answer. The S&P 500 returned 20.3% in 1942 and averaged 17.3% for the following 10 years, which was 15.1% per year better than the return on bonds.

6. Pull out is the correct answer. Although the JAPAN LARGE CAP INDEX earned 8.9% in 1991, the 10-year investor only averaged 0.3%, which was 10.1% less than the U.S. bond investor averaged.

7. Invest is the correct answer. The U.S. SMALL CAP GROWTH INDEX yielded 48.1% in 1991 and averaged 16.1% for the following 10 years despite finishing up with large losses when the tech bubble imploded.

Conclusion: Staying invested is usually the right answer, even when the world is bracing for war or in the midst of a recession. Reviewing the two “pull-out” scenarios listed here is not a black eye on diversified long-term investing. The lesson from the NASDAQ market is to limit your exposure to any sector of the economy that is displaying bubble-like qualities and ignore those commentators who justify this excess by proclaiming we are in a “new era.” The lesson from the Japan market is to limit exposure to countries that are restricting their economic freedoms. This could mean not allowing poorly managed companies to fail or raising individual and corporate tax rates. When using a globally diversified portfolio in countries exhibiting both economic freedom and low debts and deficits, the answer for the long-term investor has always been to stay invested.

 


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About Matthew Illian

Matthew Illian is on the Investment Committee at Marotta Wealth Management, Inc., specializing in small business consulting and retirement plans. He loves spending time outdoors, the less pavement the better, with his wife and three energetic boys. Favorite trails: Forest Hill Park

Comments

  1. Vern says:

    Hi Matt
    I have a question about this question . If Tim is invested in a fund family that allows change within the family would this allow him to move his money when he felt safer in doing so(whats the down side of that?? ) .& if so what would the indicators be ?

    Also Is this doable in ETF’s ?.
    How do we spot a bubble before it bursts ?
    Thanks
    Vern

    • Vern,

      The danger of attempting to move in and out of the markets is that most lose money in the process. One of the best studies to illustrate this point is the one performed annually by Dalbar.

      This study reveals that the average investor always underperforms the market average. For the last 20 years, the average equity investor has earned 3.83% and the S&P 500 has earned 9.14%. This 5.31% difference is lost because investors typically do the exact opposite of what they should be doing – behavioral finance malfunctions. If you read through the questions above and tried to imagine yourself investing in those environments, I think you will understand how easy it is to pull out of the markets at the wrong time. Humans are wired to run from fear. The markets are inherently volatile but they are also historically rewarding. The investor who is swayed by the market mayhem will likely be selling their stock to a contrarian investor who is willing to purchase investments that are being shunned by the fearful public. As we speak, European stocks are the cheapest we have seen in many years. At the same time, many in the investing public are shedding their global and foreign exposure because of this fear.

      While Tim is likely to lose money attempting to time the markets, there is a 40% chance that he might correctly pick when he gets in and out. This would be the worst outcome. Why the worst? Because if Tim is right, he will begin to deceive himself into believing that he has predictive ability beyond that of the highly paid equity fund managers and he will likely to continue to time the markets.

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