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Friday, May 29, 2015

Market Timing ...The Crowd Makes It Impossible for The "Experts",,,Or Anyone Else

At the Research Affiliates blog they posted a great article entitled

Calling the Turns: Why Market Timing Is So Hard

My takeaway. "Expert " analysts have so little success in timing markets because market prices are controlled by investors (certainly not confined to individual investors( who make decisions based on factors other than financial analysis. What an expert would call an overvalued market is simply not a determinant of how most investors make decisions, and those "uninformed" investors make their decisions based on other factors. And the most important factor not surprisingly is recent market performance.

Academic research and simple market observation shows that such behavior creates a momentum factor. We know it exists but it is very difficult to profit from (by knowing when to buy or sell) in excess of buy and hold. Most technical analysis is based on momentum. And much to the chagrin of academic economists a simple 200 day moving average has a fairly good record for giving market buy/sell signals.

From the article

The Market in Theory
The standard model of investment management equips portfolio managers and traders reasonably well to determine if an individual stock is fairly valued. Most investment professionals use discounted cash flow (DCF) analysis to estimate a stock’s inherent worth,3 and so to judge whether it is mispriced. With a handle on a stock’s true value, an investment professional can also observe the extent to which the market may have mispriced it. Similarly, by comparing the market’s current cap-weighted price/earnings to the long-term average, analysts can judge whether, and by how much, the market as a whole is misvalued. 

But DCF analysis, P/E multiples, and other theoretically sound valuation measures cannot tell us how much more misvalued the market will get nor can they explain the wild swings we’ve experienced in the two equity market cycles in the last 15 years.4 As Figure 1 illustrates, the stock market seems to go too far in both directions—up and down—and the amplitude of these movements cannot be satisfactorily explained within the cool analytical framework of the standard model. 

Empirical research has established that sooner or later stock prices revert toward their long-term averages. There is also strong evidence that the value premium is mean reverting (Hsu, 2014). If the market rises or falls to an extreme level despite a natural tendency to self-correct, then countervailing forces must be at work. .....

What are those countervailing forces ? Some insights from two Nobel Prize Winners in economics Daniel Kahneman and Vernon Smith neither of them believers in the efficient market theory which would argue markets are always rational:

One hypothesis is that many market participants view mental effort as an avoidable transaction cost. Disinclined to gather and analyze solid information about the stocks that interest them, they are carried along by the crowd, trading on momentum and noise. 

In addition to this kind of indolence or inertia, Daniel Kahneman and others have described a number of cognitive biases and patterns of emotionally charged behavior that affect individuals’ choices under uncertainty—the selling and buying of securities being an excellent example of such an activity. They include overconfidence and the illusion of control,5 mental accounts, availability cascades, loss aversion, overreacting to news, and herding, among others
Smith, the experimental economist who shared the 2002 Nobel Prize in Economic Science with Kahneman, distinguishes between constructivist and ecological rationality. The former involves the intentional use of reason to analyze the given and to advocate a course of action. (The standard model of investment management is a sterling product of constructivist rationality.) Ecological rationality, in contrast, emerges in institutions, such as markets, through human interaction rather than by human design. 

“Predominantly,” Smith  writes, “both economists and psychologists are reluctant to allow that na├»ve and unsophisticated agents can achieve socially optimal ends without a comprehensive understanding of the whole, as well as their individual parts, implemented by deliberate action.” But in Smith’s account, personal exchanges gave rise to impersonal markets which serve to facilitate the specialization that creates wealth. Smith demonstrates that in a diverse set of circumstances, such as the airlines’ response to deregulation, FCC spectrum auctions, and a variety of trust games, the interaction

Is all lost for the rational knowledgeable investor ? The author indicates that some use of tilting towards owning low valuation stocks has potential for outperformance or at least better risk/return. And the evidence of long term outperformance of low valuation to high valuation stocks is strong. But it should be noted that the folk at Research Affiliates have developed such strategies for several mutual funds and ETFs,:

At this juncture, we must acknowledge that financial theory does not provide clear and timely trading signals. Calling the turns is hard because we don’t have a mechanics of mean reversion. Our best theories—including behavioral finance, neuroeconomics, experimental economics, and evolutionary psychology—do not enable us to foresee the sudden exogenous shock that will trigger a reversal, or to sense when a gradual change in investors’ attitudes will reach the tipping point. Not even the most skilled and experienced asset allocators can pinpoint in advance the onset of a reversal. Most of us are well advised not to attempt market timing. The soundest plan is to choose a strategy that suits our investment objectives and risk tolerance—potentially including a disciplined smart beta strategy that systematically rebalances over time—and to stick with that choice for the long term.   

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