- Soaring inflation and record market highs may leave investors wondering whether it’s time to adjust their portfolios.
- Researchers have examined a wide range of timing strategies based on earnings, dividends, interest rates, economic growth, and more.
- A recent Morningstar report showed that investors may be better off steering clear of tactical asset allocation strategies and avoiding making short-term shifts among asset classes.
After touching record highs in early January, US stocks(1) have slumped, and investors have been confronted with worrisome headlines(2) in the financial press:
- “Inflation Hits Fastest Clip Since ’82” — Gwynn Guilford, Wall Street Journal, January 13, 2022
- “Economists Cut Back Growth Forecasts as Threats Pile Up” — Harriett Torry and Anthony DeBarros, Wall Street Journal, January 18, 2022
- “Giant Stock Swings Send Some Into Bear Territory” — Gunjan Banerji and Peter Santilli, Wall Street Journal, January 18, 2022
- “Markets Drop as Turbulent Trading Persists” — Gunjan Banerji and Will Horner, Wall Street Journal, January 26, 2022
- “Fed Set to Start Increasing Rates by Mid-March”— Nick Timiraos, Wall Street Journal, January 27, 2022
Some stocks that attracted intense interest last year have fallen sharply from their previous highs, as Exhibit 1 shows.(3)
Is rising inflation a negative for equity investors? Do large losses in a handful of popular stocks signal a downturn ahead for the broad market?
Invariably, the question behind the question is, “Should I be doing something different in my portfolio?” This is just another version of the market timing question dressed in different clothes. Should I sell stocks and wait for a more favorable outlook to buy them back? More precisely, can we find clear trading rules that will tell us when to buy or hold stocks, when to sell, when to admit our mistakes, and so on?
The lure of successful trading strategies is seductive. If only we could find them, our portfolios would do so much better.
Consider Felicity Foresight. She is gifted with the ability to identify patterns in the champagne bubbles floating to the top of her glass on New Year’s Eve, enabling her to predict the best performer between S&P 500 stocks and US Treasury bills over the subsequent 12 months. How would her hypothetical portfolio have performed over the past 50 years following this simple annual readjustment strategy?
Rather well. Following a Perfect Timing strategy by investing in the best performer each year, she turned $1,000 into $1.8 million, nearly 10 times the wealth produced using a buy-and-hold strategy for the S&P 500 Index (see Exhibit 2).
But also consider Hapless Harry. He was never a fan of New Year’s and manages to get it wrong each and every year. His Perfectly Awful strategy winds up losing money over the same 50-year period.
Motivated by the substantial payoff associated with successful timing, researchers over the years have examined a wide range of strategies based on analysis of earnings, dividends, interest rates, economic growth, investor sentiment, stock price patterns, and so on.
One colorful example, known as the Hindenburg Omen, had a brief moment of fame in 2010. Developed by a blind mathematician and former physics teacher, this stock market indicator took its name from the German airship disaster of 1937. The Omen signaled a decline only when multiple measures of 52-week high/low prices and moving averages all turned negative. This indicator had correctly foreshadowed major downturns in 1987 and 2008. When it flashed a “sell” signal on Thursday, August 12, 2010, internet chat rooms and Wall Street trading desks were buzzing the next day, Friday the 13th, with talk of a looming crash, according to the Wall Street Journal.(4) But no crash occurred, and the S&P 500 had its highest September return since 1939.(5)
The money management industry is highly competitive, with more stock mutual funds and ETFs available in the US than listed stocks.(6) If someone could develop a profitable timing strategy, we would expect to see some funds employing it with successful results. But a recent Morningstar report suggests investors should be wary of those claiming to do so. The report examined the results of two types of funds(7) , each holding a mix of stocks and bonds:
- Balanced: Minimal change in allocation to stocks
- Tactical Asset Allocation: Periodic shifts in allocation to stocks
As a group, funds that sought to enhance results by opportunistically shifting assets between stocks and fixed income underperformed funds that simply held a relatively 3 Dimensional Fund Advisors Please see the end of this document for important disclosures. static mix (see Exhibit 3). Morningstar further pointed out that if the performance of non-surviving tactical funds were included, the numbers would be even worse. Its conclusion: “The failure of tactical asset allocation funds suggests investors should not only stay away from funds that follow tactical strategies, but they should also avoid making short-term shifts between asset classes in their own portfolios.”(8)
We should not be surprised by these results. Successful timing requires two correct decisions: when to pare back the allocation to stocks and when to increase it again. Watching a portfolio shrink in value during a market downturn can be discomforting. But investors seeking to avoid the pain by temporarily shifting away from their long-term strategy may wind up trading one source of anguish for another. The initial upsurge in prices from their lows often takes many investors by surprise, and they find it extraordinarily difficult to buy stocks that were available at sharply lower prices a few weeks earlier. The opportunity cost can be substantial: Over the 25-year period ending in 2021, a hypothetical $100,000 invested in the stocks that make up the Russell 3000 Index would have grown to $1,036,694.(9) But during this quarter-century, missing just the best consecutive 90-trading-day period (which ended June 22, 2020) shaved the ending wealth figure by an alarming 33%.(10)
Add to this the likelihood of increased transaction costs and the potential tax consequences of a short-term trading strategy, and the odds of adding value through market timing grow even slimmer.