At the end of every year, the media likes to publish stock market forecasts for the year ahead. Tempting though it is to pay them close attention, the problem with market timing is forecasts are notoriously inaccurate.
How, then, should investors view the ups and downs of the market? And what, if anything, can they do about them?
ELROY DIMSON from Cambridge Judge Business School is a world-renowned financial market historian. He’s also Professor Emeritus at London Business School and is a consultant to the board at Sparrows Capital, one of TEBI’s strategic partners in the UK.
In this, the first part of a two-part interview, Professor Dimson explains how, at least in the short term, market movements are extremely hard to predict.
We’ve had a very long bull market, and, understandably, people are beginning to wonder when it might end. Is it possible to predict when a bear market is about to begin?
It’s very popular to ask investment experts how to predict, or whether they can predict, declines in the market. It’s a very difficult thing to do. What we can predict is volatility. When markets become volatile and start moving up and down, then the likelihood of an extreme move is amplified. So, in that sense, we can predict when a market is more likely to fall. But it’s also going to be more likely to increase in value.
We’ve entered a particularly busy period for stock market predictions, haven’t we?
Yes, it’s quite common, at the turn of the year, for predictions to appear in the financial press. What you tend to find is that commentators extend trends more often than they forecast reversals. So, if you see that markets have been going up, what you find is that the forecast for the next quarter — or the next half-year, or the next year — is more likely to be favourable than it is to predict a crash. So commentators actually are “trend chasers”, in that sense. They’re not people who believe in reversals being more likely.
Why then, if it’s so hard to do, are so many investors tempted to try timing the market?
I think that’s straightforward. If you buy an investment, hold it for a period and then sell, your performance depends on three things. They are the price at which you bought, the income you get over the periods while you hold the investment, and the price at which you sell. So, market timing must involve asking whether it’s a good time to buy, and when it’s a good time to sell to avoid a decline. So it’s natural to focus on that as well as on the level of income that might be generated by an investment. But there is a problem and the problem is that, oftentimes, when people make a prediction, they get it wrong. And the cost, for example, of trying to avoid the worst times or capture the best is that you might get it completely wrong. That simply increases the risk, over the long haul, of your investment portfolio.
Of course, most market falls turn out to be corrections. Full-blown crashes are relatively rare, aren’t they?
Yes, investors are often concerned about quite minor perturbations in the market, but what really matters is the possibility of a crash. There have been huge crashes over time. The First World War, the Second World War, the 1929 Wall Street Crash — those are parts of legend. But, in more recent times, there have been crashes in the market where there’s been a huge loss in value. It happened at the end of the tech bubble at the run of the century, and again at the onset of the global financial crisis. Those are big crashes and what they were associated with was quite substantial double-digit falls in major market indices.
Some people might say “well, a crash means a loss in value of, say, 20%”; and what we would talk about is whether there’s a loss in real value — that is, taking account of inflation over that period. So that’s a crash. Now, the vibration you see in markets will sometimes extend to a sort of “mini crash” — in other words, there may be a drift down with a recovery afterwards, and that drift down will be referred to by commentators as a correction: “Prices were too high, and then they corrected and went to a more sensible sort of level.”
That’s just the normal sort of outcome that any equity investor has to be comfortable with, although they also have to expect major losses in value occasionally as well.
You referred earlier to periods of volatility when prices are more likely to fall or rise sharply. How long do those periods tend to last?
The times when markets are most volatile are captured by an index that’s known as the VIX, which monitors the volatility of the US stock market. So, what you find is that the VIX will shoot up a great deal at times of stress in the market, such as in 1987, when there was a crash followed by a very speedy recovery, or going back to the Far East currency crisis or the Russian defaults, and so forth.
So, how fast does volatility return to the long-term average? The answer is that volatility returns to the long-term average incredibly fast. Typically it takes a few months, and often only a few weeks of volatility to revert from a spike, which might be very large), to the long-term average. There are even occasions where that volatility has returned all the way to the average within seven days, and half-way towards the long-term mean within one to two days. That’s about the fastest that it’s happened. So, volatility and the risk of a crash or a correction can disappear quite quickly. Long-term investors can see through those short-term perturbations in markets.
We’ve had a long bull market. How long, historically, do bear markets tend to last? And how often do they tend to happen?
How long is a piece of string? The deeper the definition of the bear market, then the more infrequent it is. A slightly different take is to ask ourselves, what is the most extreme occurrence that might happen if there is a decline in the value of equities in a particular country? Or a decline in the value of bonds in a particular country? What might the drawdown be and how long it might it take to recover.
When it comes to equity markets, almost all countries have had periods where, for 20 years or more, equities have been underwater. That is, if you bought at the wrong time, you haven’t made any money in real, inflation-adjusted terms until 20 or more years have elapsed. When it comes to bond markets, it has, over the course of history, taken more than half a century to recover if you bought at the wrong time — just to get back to where you started. In a number of countries, it has taken more than a century.
That’s a very sobering reminder of the importance of diversification. But even if you’re very diversified, you’re still going to suffer in a bear market. You can see why investors are so keen to avoid them.
The question to ask is, what’s the risk of being out of the market for a period of time? One way of thinking about that is asking, what happens if you manage to capture the very best days, or manage to avoid the very worst days? Clearly, if you could manage this, then performance would be aided or hurt by capturing good days and avoiding bad days, or the opposite. The dilemma that you face, as an investor, is that, while it’s conceivable that you could forecast the future, it is exceptionally unlikely. On the other hand, it costs something to jump in and out of the equity market. So a buy and hold strategy is going to have fewer costs, and is going to outperform compared to timing your entries and exits.
ELROY DIMSON chairs the Centre for Endowment Asset Management at Cambridge Judge Business School, and is Emeritus Professor of Finance at London Business School. He chairs the Policy Board and the Academic Advisory Board of FTSE Russell and is an adviser to the board of TEBI’S strategic partner, Sparrows Capital.
More from Elroy Dimson on The Evidence-Based Investor:
Elroy Dimson on ESG and whether to invest in collectibles
Elroy Dimson on the most important lesson in market history
Image: Agê Barros (via Unsplash)