Heading into 2022, many investors were optimistic about the equity markets. All major asset classes generated positive results in 2021. Equities reached record highs, and the S&P 500 returned 28.7% on a total return basis. As of year-end 2021, the S&P 500’s 10-year annualized return stood at 16.5%, compared to its long-term average return of about 11.9% (1928 to 2020). In addition, investors felt that inflation was “transitory,” that the worst of the supply chain disruptions were behind us as COVID-19 came under control, and that global growth remained on track for solid gains. It appeared to many investors that this combination of circumstances would lead to positive market performance in 2022, albeit less than what investors realized in 2020 and 2021.
With this as a background, imagine if one of our Brown Brothers Harriman (BBH) colleagues could then have accurately predicted the macroeconomic and political events of 2022. Even if this was possible, it would be difficult to describe a forecast for 2022 that would be as dire as the actual events: Russia’s invasion of Ukraine leading to record-high energy and food prices for Europe and many emerging markets, continued supply chain disruptions due to labor shortages and China’s zero-COVID policy, the fastest increase in interest rate hikes by the Federal Reserve in 40 years to tame inflation that reached 40-year highs, and rising risks of a global recession, among other events. A prediction of just a fraction of the turmoil of 2022, coupled with the known performance data from 2021, would have likely led many investors to move most liquid assets to cash as a result of this information.
Of course, investors would love to be able to time the market perfectly, investing at market bottoms and moving to cash at peaks. Unfortunately, such market timing is challenging for all investors, no matter how sophisticated. We adhere to the adage that “it is about the time in the market, not timing the market” which allows investors to best position themselves for strong long-term results. A long time horizon that benefits from the power of compounding is much more impactful, and generally more successful, than the mirage of market timing. The case against market timing is strong and supported by a large body of research conducted by BBH as well as academic studies. We believe that instead of trying to time the market by monitoring broad market, economic, or political indicators, investors should utilize a bottom-up, fundamental approach with a long-term horizon to select high-quality individual securities trading at a discount to estimates of intrinsic value. Such an approach is the most predictable way to generate attractive long-term returns. In addition, investors are also well served by implementing a thoughtful, programmatic rebalancing strategy that optimizes the benefits of such actions with the potential tax consequences.
What Is Market Timing?
We define market timing as the speculative strategy of making buy or sell decisions based on predictions of short-term market price movements. Importantly, market timing decisions are based on estimating the returns of the market (or corresponding index), such as U.S. large-cap stocks, rather than a particular security.
Market timing strategies can involve several different approaches. One approach employs using nonfinancial indicators to predict market movements. For example, one may attempt to predict what may happen to U.S. equity markets if a given presidential candidate were to win an upcoming election. Such an investor may determine that the risk of an unfavorable candidate winning the election warrants staying out of the market until the election is resolved. Another approach involves the use of technical indicators, such as historical prices. In this case, an investor engaging in market timing might notice that the MSCI ACWI has generated positive returns for the past five years and thus may decide to wait for the “bubble” to burst. Yet another common approach is timing based on historical market valuations. An investor utilizing this approach may make valuation comparisons across time or different markets. For example, one might compare the S&P 500’s price-to-earnings (P/E) ratio today vs. its P/E ratio in 2009 or vs. the MSCI Emerging Markets Index’s current P/E ratio. While keeping track of each of these data points can be helpful, attempting to make entry or exit decisions based on them is likely to be detrimental to long-term returns. There are simply too many other variables that influence market returns over the short to medium term. It is also difficult for anyone to make accurate predictions on such macro issues over a long period of time.
What Is the Allure of Market Timing?
Despite the abundance of evidence suggesting that market timing is a futile exercise, its allure persists. Why? One hypothesis is that this strategy is a response to the legitimate realities of investing as well as behavioral biases. Specifically, all investors can see how beneficial it would be if one could predict market movements and adjust a portfolio in advance of those movements. If it were possible, doing so would allow one to dramatically outperform the gold standard of a buy-and-hold strategy over the long term. For example, if an investor could exit asset classes that were going to generate poor performance over the next year and rotate into asset classes that would generate strong performance over the same period, returns would be enhanced, volatility would be avoided, and losses would be curtailed.
Looking at the nearby chart, the “all-knowing” investor would have moved out of developed international and into small-cap equities at the end of 2015, only to rotate into emerging market equities at the end of 2016. In theory, that investor would be able to generate returns at a level rarely attained. If we assume that from 2007 to 2021 the investor was able to rotate 100% of her portfolio at the end of each year out of the highest-returning asset class for that past year and into the highest-returning asset class for the following year, she would have generated an annualized return of 25.6%, gross of fees and taxes, meaningfully outperforming the otherwise impressive 11.5% annualized return of U.S. large caps over the same period. Despite this return potential, we rarely hear of people who have accumulated vast sums of wealth this way. As Peter Lynch said, “I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”