We often get questions like the following from our clients:

“Do you think the market is going to keep going up?”
“We’re due for a correction soon, don’t you think?”
“The market has hit an all-time high. Should I hold off on investing my cash?”

What we are fundamentally being asked is what we think the market is going to do in the near-term, and if we’re being honest, it’s a question we dread (although we understand why clients ask!).

These questions presuppose that:

1. With enough skill or knowledge, the near-term direction of the market can be predicted, and therefore,

2. That investment decisions should be made based on that prediction.

By attempting to answer these questions, we run the risk of affirming presuppositions that we may not agree with in the first place; namely, that markets and investments can be timed. In this piece, we wanted to delve into why we avoid the practice of market timing. We approach this by examining industry data and offer takeaways on how we apply our findings.

What is market timing?

Market timing is the strategy of buying or selling investments in anticipation of a short-term market gain or loss. The following transactions are common forms of timing the market:

1. Moving investment money in or out of financial markets

2. Switching funds between different asset classes

3. Shorting financial markets (i.e. profiting when the market goes down)

Key to the approach is formulating a near-term prediction of what will happen in the market, a behavior we observe almost everywhere from financial news to conversations between friends. Just a quick google search yields headlines like the ones below, inviting readers to buy into the latest hype.

The strategy itself is simple to understand. If you could just participate in the markets when they rise and sell your investments before they fall, you would accelerate growth and avoid downside volatility. In the last 20+ years, the stock market has experienced tremendous ups and downs, so naturally, any strategy offering a way to avoid future downturns is enticing! But like many things in life, if it sounds too good to be true, it usually is. And that is certainly what we found to be the case with market timing.

Measuring the Success of Market Timing

To evaluate an investment strategy, it is essential to distinguish how much luck versus skill is necessary for its success. The more a strategy depends on luck, the less it can be counted on to produce results in the future. To differentiate between these two factors, we needed to examine the repeated success of market timing over a long period of time.

As we sought out a relevant data set, we ran into some challenges. Despite its widespread use, there is little consistency in reporting the practice and success of market timing, and for obvious reasons, investors are not eager to publish the details of failed attempts. Therefore, we decided to examine market forecasting as a proxy for timing strategies. Forecasting when prices will increase or decrease is at the core of the approach, so evaluating the success of this practice can help us determine whether market timing is a viable strategy.

Short-Term Market Forecasts

Conveniently for our purposes, analysts from major Wall Street institutions make annual predictions on market returns for the upcoming year. These forecasts are typically released toward the end of each year through financial news outlets and with a bit of digging, can be compiled into a standardized data set. We discovered that a statistician and former Columbia University professor named Salil Mehta had gathered these one-year predictions along with the corresponding actual market returns and made the information available to the public. After updating his work to include forecasts from the most recent years, we had a data set that contained a total of 206 predictions made by 39 institutions from 2001 to 2020.

The Results of Wall Street Predictions

Upon analyzing Mehta’s data, we observed that Wall Street forecasts have been wildly incorrect. On average, forecasts were off by 13 percentage points from the actual return (e.g. if analysts predicted a 10% market return and the actual return was -3%). In three of the years, the average prediction was off by 30 percentage points or more. Furthermore, the average market forecast failed to predict every negative return year.

Comparing the predictions and the actual market return, we found that 40% of annual average predictions were incorrect by at least 10 percentage points.

To get a little more technical, we plotted the actual and predicted returns on a scatter plot and added an identity line (shown in red). The identity line represents points along the graph where forecasts and actual returns were the same. If analysts were accurate market forecasters, we would have expected to see the plotted data hovering near the red identity line. Instead we found the points veer away in a random pattern, indicating little accuracy in the predictions.

We also displayed a trend line (shown in dotted blue) and found that it was downward sloping with an extremely low R-Squared value of 0.15 (low R -Squared in this case indicates how poorly market forecasts predicted the actual returns). The slope suggested that not only were analysts poor market predictors, but the market tended to perform in an opposite direction to what was predicted. When analysts predicted a below-average performing year, the market tended to have an above-average year, and vice versa.

Why is it so difficult to predict the markets?

Based on the results of this brief analysis, it’s clear that even industry experts who have access to information and resources far beyond the average retail investor were unable to even marginally predict the market. But some readers may find this puzzling. How can it be when so much money, technology, and human capital are being poured into their forecasts? We offer a few theories:

1. Too many variables
   There are simply too many variables to consider: thousands of autonomously operating businesses, millions of market participants making independent decisions, and an infinite number of underlying factors that span the global economy. And besides the sheer number of variables, it’s impossible to truly understand how each point reacts to each other and influences the entire system.

2. Unforeseeable shocks
   Natural disasters, global pandemics, wars, and other massive yet unforeseeable events can enter the model at any point and completely change the assumptions. Even in recent history, events like the 9/11 terrorist attack and the global pandemic had direct influences on short term stock market behavior.

3. Human emotion
   The collective fear and greed of investors can drive the market into prolonged recessions and booms. Herd psychology can impact both short term and long-term market behaviors in ways that are difficult to measure and even more difficult to predict.

Our Takeaways

In conclusion, we remain skeptical toward market timing as a sound investment strategy. When the brightest minds in the industry struggle to make accurate predictions, it’s hard for us to believe that skill is a major determinant factor in the strategy’s success. Market timing has always and perhaps will always be a tantalizing approach. It feeds on basic human emotions like aversion to loss and desire for short-term gain. Rather than participating in what we believe to be a flawed and risky practice, we offer the following alternative principles:

1. Know what we don’t know
   We should have a clear understanding of our area of competency and be cautious to venture outside of it. Market timing is certainly outside of our (or anyone’s) ability, so we will avoid it.

2. Stay invested
   Every market crash has been followed by a period of recovery and growth, while the data shows that attempts to consistently predict downturns are largely unsuccessful.

3. Take a bottom-up approach
   When making an investment decision, we should focus on discerning the quality of the investment at the individual business level.

We believe these simple principles will serve us and our clients well when navigating the ever-changing landscape of financial markets and guard us against ubiquitous claims that short-term market behaviors can be anticipated. The point of this post as well as our overall investment philosophy is succinctly captured in the following quote by legendary investor Warren Buffett: “I make no attempt to forecast the general market --my efforts are devoted to finding undervalued securities.”

We hope you have found this piece helpful. If you have any questions or would like to discuss this topic further, please do not hesitate to contact us at team@jsopartners.com