Stein & DeMuth's Market Signals Go Green Across the Board

Almost a year ago when I reviewed (here) Ben Stein and Phil DeMuth's book Yes, You Can Time the Market, only a couple of indicators / buy signals were green, indicating a good time to buy the S&P 500. Now all four indicators for which they can still get data - Price, P/E Ratio, Dividend Yield and Earnings Yield vs AAA Bonds - are Green. Thought you'd like to know. Let's note that the S&P 500 as I write this is at 1165.47.

Book Review: Yes, You Can Time the Market! by Ben Stein and Phil DeMuth

Market timing is normally not my thing but after reading this book I accept that, Yes, you can time the market with Stein and DeMuth's method. The only thing is the method requires that you have the patience of Job and the lifespan of Methuselah. What investor would be willing to not buy / not invest in the market for 17 years waiting for the buy signal to begin flashing? The book's buy signal test was a red "no-go" for the whole time between 1984 and 2001, a period during which the S&P 500 (used as the US market proxy throughout the book) experienced huge unprecedented gains. Similarly, the twelve years between 1954 and 1966 was another long period for an investor to sit on cash or money market accounts according to Stein and DeMuth . The authors' goal to show conservative investors how to make money in the long run is truly vulnerable to Keynes famous quip that in the long run, we are all dead.

The Yes market timing method works as follows:

• objective - determine when the US market is over-valued, in which case don't buy, or under-valued, in which case buy
• assess over-/under-valuation with four real after-inflation metrics: price, price/earnings, dividend yield, earnings yield vs bond yields, price to sales, price to cash flow and Tobin's Q (a measure of fundamental value of companies; each individual metric works but several simultaneously saying Yes works even better
• the current value of the metric is compared against the trailing 15 year average
• valuation is applied against the market index only - the S&P 500; it is explicitly not proposed to be used for individual stocks
  
• wait ten years or more (the longer you wait, the better, though their testing only goes up to twenty years) to achieve far superior returns than you will get whether investing at random as an average of years or on a continual dollar cost averaging schedule.
• when signals are saying are saying No, it only means don't buy, it doesn't mean sell; you keep whatever stock investment you have and simply wait till the next buy signal.
  

This last point has caused other reviewers (e.g. at Amazon) to accuse the book of not really being about market timing. To be a market timing purist you must be jumping in and out and in etc, it seems. Similarly, the book violates another cliche image of market timing, that it is only about short-term timing in days, months or perhaps year to year, but not decades, which is the case here.

For the most part, the analysis and comparisons make a convincing case for the authors' thesis. Using 100 years of market data, rolling periods and looking at results after 5, 10, 15 or 20 years of holding after purchase builds confidence that the data was properly compiled. There is also economic logic supplied as to why the indicators should work.

Where the argument isn't convincing is the comparison of dollar cost averaging vs their market timing using 1977 as a starting point. In 1977 the buy signals were flashing so the market timer got their money into the game a lot sooner than the DCA investor. With a subsequently rising market, the market timer was bound to win.

It is very useful for the book to contain all the year by year tables of past signals, both buy and don't buy, along with subsequent results of the 5-20 year holding periods. That reveals a key fact - the market timing system did not produce great returns every time it said buy (e.g. buying in 1973 produced only a 251% gain 20 years later) , just as buying in many years when the system said it wasn't propititious to buy produced outstanding returns in subsequent years (e.g. buying in 1982 gave off a gain of 582% after only 15 years). The system appears to produce better returns on average.

Chapter 8 titled Using Market Timing contains a lot of very sensible cautious advice for investors, the antithesis of a get rich quick mentality that one might suppose a book on market timing might present - e.g. "Never make a "bold" investment decision; Don't think big; Don't make any sudden moves".

The book was published in 2003 so the data series stop too soon for us to find out what any reader wants to know - what is the situation today, is the market over or under-priced and is it time to buy? Fear not, the authors have continued to update the metrics on the book website http://www.yesyoucantimethemarket.com/index.html. As of Oct.30th, 2009, it shows for the S&P 500 - Price - Green! BUY!; P/E Ratio Red! Don't Buy!; Dividend Yield - Green! Buy! (They say also that data for several other indicators is no longer available.) That should mean it's a good time to buy.

Stein and DeMuth posit that their method should work on other markets, though they haven't tested. It might/should given its essence is to identify times when a market is clearly under-priced in historical terms. Of course, the method also rests on the assumption that the future will be like the past, that reversion to past means will occur.

My rating: 3.5 out of 5 stars.

Market Timing Can Work ... If You Wait a Few Decades

Mebane T. Faber shares his intriguing market timing system in A Quantitative Approach to Tactical Asset Allocation on SSRN (original 2006, revised February 2009). His system produced significantly higher compound returns and much lower volatility / standard deviations over many time periods and multiple asset classes (US equities, MSCI EAFE international equities, US REITs, US government bonds and commodities). The intriguing aspect is that the paper was originally published in May 2006 and went through the trial by fire of 2008, during which it performed beautifully and would have protected an investor. Instead of the 37% loss of the S&P500 with buy and hold, Faber's method would have given a 1% gain!

Faber's buy-sell rules are ultra-simple: buy when the month-end price of the asset is greater than the 10-month moving average and sell when it is less, keeping the money in cash until the signal changes. That would have kept an investor in the five asset classes he looked at invested about 70% of the time and generated less than one portfolio turnover per year (i.e. minimal effort and low transaction costs required). It's a system akin to Larry Macdonald's One-Minute Portfolio for Canadian RRSP investors, which also escaped 2008 relatively unscathed with only a 10% decline according to his Dec. 18th update.

The downsides?

1. Will the future be like the past and will the system continue to work? Fitting a system to past data can be made to work - it is a statistical version of "hindsight is 100% accurate". Faber's worked in 2008, after he had developed the system in years prior, but what about the future? One never knows for sure.
2. In strong upmarkets such as the 1990s (Faber is upfront about this in the paper - see Appendix D on pages 39-40 for the S&P500 vs the timing system stats decade by decade), the system underperforms, and can do so by a lot. Could you stand being left behind over the two decades of the 1980s - by 2% annually - and the 90s - by 5% a year? How much return should one sacrifice for disaster crash avoidance? After 2008, many "deferred-retirement" folks might regretfully say Faber's system is worth it. Just because we've had one shock in 2008 and things seem to be on the rebound for now, that doesn't mean we couldn't have another big drop soon (e.g. suppose the swine flu gets deadly in the fall, then as they say, "you ain't seen nothin' yet" for market turmoil).
   

Bloggers tell institutional investors to stay calm and stick with plan as market weakens

In light of the recent article on the CBC website, titled "Advisers tell investors to stay calm and stick with plan as market weakens", a reply from the blogosphere is called for.

The CBC says:
"After a nearly five-year run, investment advisers say it's time to stay calm, review your investment plan and look to defensive plays such as utilities, health care and consumer stocks to wait out the slowdown."

... Bloggers say it's time time to stay calm, stick with your investment plan, look for stock bargains among long-term high-quality companies and wait out the slowdown.
"Me? I’m sticking to my plan and giving this all some time to settle out." Canadian Dream: Free at 45
"During Monday’s panic, I actually went out and bought more banks." CanajunFinances
"Often the best thing to do is nothing, especially when our emotions are getting the better of us." Michael James on Money
"At times like these, amidst breathless front-page coverage of every gyration in the stock market, you can dust off your copy of The Intelligent Investor and find solace in the counsel of Benjamin Graham." and goes on to quote words saying to stay calm. Canadian Capitalist

Let us also note the results of a small informal poll conducted on this very website regarding the severe market slide of January 15-17. In answer to the question about what they did in response, 39% of readers said they bought stocks they considered a bargain, 71% said they did nothing and were going to wait things out, 0% said they sold to pay for Christmas expenses or for other expenses and 0% (yes, that's a big fat ZERO) said they sold equities! Yes, sir, the average person on the street sure was panic selling!

In contrast, the CBC article quotes mutual fund managers saying, "I think you have to continually look at your portfolio and make sure you're focused on quality and to the extent that you have more speculative or lower quality investments, you may have to have make a decision to exit some of those securities," Pym said." ... and ... "Watson said defensive stocks like utilities, health care and the consumer sector will be areas investors will want to look to." Ah yes, sector rotation, tactical asset allocation, market timing, those discredited and disproved strategies. Now we know who was doing all that panic selling in the last little while.

Book Review: Against the Gods (The Remarkable Story of Risk) by Peter Bernstein

This book is a popularized introduction to the long history of the development of the theory of risk. It is a welcome and useful entryway into a vast subject as Bernstein has taken care to provide footnotes and a substantial 12 page bibliography of original material. Bernstein manages quite a feat in effectively summarizing in plain language the findings and theories of so many highly mathematical and subtle ideas.

The author's attempt to make the book more entertaining is fairly successful. The meandering descriptions of the personal foibles of the men (why not even one woman among them?) who have advanced the theory of risk along with various anecdotes and trivia (e.g. the English national debt began on Dec.15, 1693) provides amusing distraction but the cutesy chapter titles (e.g. "The Man Who Counted Everything Except Calories") are an annoying artifact of our times.

The book is replete with bold sentences that make wonderful quotes (see below). I found many to be very thought-provoking.

Quotes:

• At the extremes, the market is more likely to destroy fortunes than to create them. (p.150)
• It is perilous in the extreme to assume that prosperity is just around the corner simply because it has always been just around the corner. (p.172)
  
• We are in the business of managing and engineering financial investment risk. (quote of Charles Tschampion, manager of GM's pension fund; p.247); interesting because engineering only applies when the inputs and assumptions are accurate and as Bernstein states often, we cannot necessarily assume that the future will be like the past and all the assumptions are based on data about the past.
• The capital markets are not accommodating machines that crank out wealth for everyone on demand. (p.251)
  
• Investors diversify their investments because diversification is their best weapon against variance of return. (p.252)
• Well-informed investors diversify because they do not believe that investing is a form of entertainment. (p.275)
• It is hard to over-estimate the importance of house price trends for consumer psyches and behavior. ... Consumers view their home equity as a cushion or security blanket against the possibility of future hard times. (quote of former US Federal Reserve Chairman Alan Greenspan, p.290); given the current slide of house prices in the US, one has to wonder what the repercussions will be on consumer spending and economic activity.
  
• ... investors had met the enemy and it was them(selves) ... (p.303)
• ... if all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized. (quote of former US Federal Reserve Chairman Alan Greenspan, p.328)
• ... in spite of all of our efforts, human beings do not enjoy complete knowledge of the laws that define the order of the objectively existing world. (p.330)
• Uncertainty is a consequence of the irrationalities ... in human nature, ... (p.331)
• Wars, depressions, stock market booms and crashes, and ethnic massacres come and go, but they always seem to arrive as surprises. (p.334)
• ... diversification is not a guarantee against loss, only against losing everything at once. (p.336)
  

I wish Bernstein would more explicitly address the difference between the research or theory that is prescriptive or normative, i.e. which says what people should do, from that which is descriptive, i.e. what people actually do. There is a danger, manifested today in investing as rote acceptance of structuring a portfolio based on a person's "risk preference", to magically transform irrational, illogical behaviour into acceptable practise. Bernstein's example (p.105) of the varying degrees of fear displayed by passengers going through turbulence in an airplane illustrates the point. Why does he describe the varying reactions with "And that's a good thing"? The risk and the consequences to the passengers are the same and presumably none actually want to die so should the reaction not be the same for all despite the observed variety of emotional reactions, however understandable that reaction might be. In a later chapter describing other research on irrational behaviour (p. 273), Bernstein writes: "This behaviour, although understandable, is inconsistent with the assumptions of rational behaviour. The answer to a question should be the same regardless of the setting in which it is posed."

There are some fascinating statements which I wish had received more treatment - perhaps in another book? One statement is that the perceptions and behaviour of investors are shaped by their own times and experience (p. 54 and 301), especially nasty painful ones, like the Great Depression of the 1930s. So, how would Bernstein characterize today's generation? Another is the surprising result that despite all the irrationalities displayed by people/investors the market for all practical purposes - the phrase he uses, borrowed from John Maynard Keynes, is "when it really counts" - operates as though rationality prevailed. In investment terms it means that it is very difficult to exploit mis-pricing, over- and under-valuation in any systematic, profitable way. A third such statement is that the advances in risk management techniques have encouraged greater risk taking. Everyday life, including especially investment management that is dominated by the professionals who supposedly practise risk management in the most extensive and sophisticated way, fall down in the most spectacular fashion. Witness the unfolding sub-prime mortgage lending credit crash and the world's biggest banks who are getting hammered, with the economic debris already starting to fall upon the heads of ordinary people.

The book is somewhat schizophrenic in that it presents the thesis of mastery and a confident answer on the one hand, but on the other hand it asks a key question to which no answer is given: "But to what degree should we rely on the patterns of the past to tell us what the future will be like?" Suppose there is no mean to revert to in the stock market, or suppose the mean has or will shift? In that case, investing theory is a house built on sand.

For the practical-minded individual investor, a quote (p.49) by 18th century gambler and mathematician Girolamo Cardano in the book gives a neat summary of the book's value: "... these facts contribute a great deal to understanding but hardly anything to practical play."

PS a small note to Mr. Bernstein, please find synonyms for the word remarkable; it is a tad over-used in this book.

Overall, a thought-provoking read, succeeds in the story-telling but leaves one confused about how to tell quantifiable risk from unknowable uncertainty and in doubt that such a goal is even achievable. Useful to individual investors to heighten their sense of the need for caution. 4 out of 5 stars.

Book Review: Juggling Dynamite by Danielle Park

Let us begin with a quote from the Preface: ''This book is not a financial planning book or a finance text.'' It is rather a polemic, a book that puts forth controversial opinions, much of which I agree with and one of which is dangerous to investors. To use the analogy in the title of Ms. Park's book, if investments are dynamite, then she advocates becoming good at knowing when to hold onto the dynamite and when to run and hide, i.e. she is an ardent advocate of market timing.

As an industry insider with experience working for an investment dealer and now running her own company managing the portfolios of private investors, she is in a good position to warn about mistakes often made by the investing public and dangers of the investing industry, things like:

• ''the key to lasting financial success is constant, conservative, diligent discipline and self-restraint''
• a primary objective must be not to lose one's capital
  
• be wary of media hype on hot companies and stocks
  
• avoid debt and be very cautious about leverage
  
• avoid putting much, most of your money into one investment - diversify
  
• avoid mutual funds that charge high fees and use low cost index ETFs instead

Park puts forth the assertion in the book that the reality of economic cycles and of market bubbles and of purported long- term economic cycles and of secular trends means that an investor should vary the amount invested in equities and cash accordingly to preserve capital and make higher returns. This is contrary to mainstream financial theory, which maintains that markets are generally efficient and reflect available information, including public data on economic activity and cycles. Park herself admits the controversy of her assertion:
''There seems to be vehemence on the part of many mainstream financial commentators to refute the notion that anyone can use market timing to the investor's great benefit. I have tried to understand why this might be the and confess I have no clear explanation.''

Unfortunately, the bulk of finance research indicates no benefit to market timing from the various systems and trading rules proposed. Park does not back up her assertion with evidence, nor does she reveal the rules she would propose to use so that the possibility she does have a system capable of beating the market could be examined. Failure to do so voids the promise on the back cover, namely that: ''This book will equip you with the tools to make your portfolio grow using active investing and market timing.''

To be more than fair (why didn't she quote this kind of stuff?), there is some research that indicates some people or some systems can successfully time the market. One is called trend following, which exploits the documented tendency of market returns to persist or to have momentum for several years. The paper by Mebane T Faber titled A Quantitative Approach to Tactical Asset Allocation, available here at the Social Science Research Network describes the ability of the rule to buy/sell equities using the 10-month simple moving average to reduce portfolio risk (aka volatility) while maintaining the same returns as buy and hold. Or, the paper The Market Timing Ability of UK Equity Mutual Funds by Cuthbertson, Nitzsche and O'Sullivan also available at SSRN, describes how a small number of fund managers demonstrate market timing ability. I didn't find any papers that use economic cycle indicators as Park proposes but maybe there is some system that can apply them successfully. The point is that the burden of proof lies on Park in addressing the reader.

Two critical problems arise, however, for the individual investor in trying to apply market timing. First, is the constant effort to track the market for the buy/sell signal and then carry out the trading required. Second is the difficulty revealed by the Cuthbertson study - a much larger number of the professional equity fund managers (10-20% vs the 1.5% who did well) did worse and subtracted value by their market timing efforts. In short, the average individual investor is almost surely best off with the passive index investing of a balanced portfolio that is occasionally re-balanced.

For what it's worth, on page 41 Park makes the bold prediction that 2000 marked the start of a 20 year bear market for equities. She recommends on page 46 holding various forms of cash, plus commodities, gold, metals and minerals but to do this with ''a timing strategy employed with discipline.''

The writing itself is uneven, sometimes ungrammatical, often inadequately labelled, documented and footnoted. The book suffers from awkward diction and phrasing that makes it seem like a first or second draft, not a polished final product. This undermines the credibility of her message.

Once again, thank you to Mike at the publisher Insomniac Press, for providing me with a complimentary copy of the book to review.

You can buy the book at Chapters.ca

Overall, there is a fair bit to like in this book, but the impractical advice to use market timing mars its usefulness for the DIY-investor. My rating: 3 out of 5 stars.