Ask the Spud: Can You Time the Markets?

Q. Have you ever done any calculations into the optimal time to purchase index funds or ETFs based on broad market indicators? I’m essentially talking about buying during market dips and corrections, perhaps based on moving averages. — Joe S.

Canadian and international stocks are now in negative territory for 2011, and even US equities have fallen more than 5% since the beginning of May. If you’re an index investor with a global strategy, does it make sense to wait on the sidelines for opportunities like this? Can you enhance your returns by identifying the right time to buy?

Let’s call a spade a spade here: this is market timing. It is always possible to look in the rear-view mirror and identify what would have been the optimal time to buy into any asset class. But trying to spot buying opportunities ahead of time, based on moving averages or other technical indicators, is likely to be futile and costly.

Besides, the Couch Potato strategy already includes a technique for buying into asset classes when they’re “cheap.” It’s called rebalancing.

About once a year—or when your portfolio’s target allocations are out of whack by a certain amount—it makes sense to trim the best performers and use the proceeds to prop up the winners to get the portfolio back to its targets. (You can use my rebalancing spreadsheet to help with the math.) But rebalancing doesn’t have to involve selling anything. Another way to keep your portfolio balanced is to add new money to asset classes that have recently underperformed.

Say, for example, that your long-term strategy calls for equal amounts of Canadian, US and international stocks. Over the last 12 months, US stocks have dramatically outperformed the other two asset classes, so your portfolio would now be out of balance. If you have new money to add, you should use it to prop up the Canadian and international equity funds until all three are equal again.

Rebalancing is not market timing

It’s crucial to understand why you’re doing this. When you add new money to Canadian or international stocks today you are not making a bet that these asset classes will outperform the US over the next 12 months. You are not making a forecast of any kind. You are simply recognizing that all asset classes should eventually revert to the mean.

Remember, the long-term expected returns for Canadian, US and international developed markets are the same. From 1970 through 2010, their performance was within 70 basis points of each other. The reason you should hold all three in your portfolio is that they do not move up and down at the same time. By diversifying and rebalancing, you reduce your portfolio’s volatility and potentially increase your overall returns at the same time.

Trying to time the purchase of index funds or ETFs based on market indicators is tempting, but it’s incompatible with a passive investing strategy. You are likely to be better off by building a well diversified portfolio, adding new money whenever you have it, and rebalancing regularly to stay on track.

Got a question about index investing? Send it to mail@canadiancouchpotato.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.

20 Responses to Ask the Spud: Can You Time the Markets?

  1. jorden June 24, 2011 at 8:35 am #

    Just to ask followup question, was it not you who said, that ZRE and XRE were overvalued because of the income trust refugees?. Not trying to be rude, I actually want to know if it was you or someone else, as I am going to purchase ZRE shortly.

  2. Canadian Couch Potato June 24, 2011 at 8:51 am #

    @jorden: No, that wouldn’t have been me. I don’t pretend to know when securities are overvalued or undervalued.

  3. The Dividend Ninja June 24, 2011 at 10:36 am #

    @Canadian Couch Potato
    A good post, and an interesting way to look at the issue. I recently topped up a U.S. index fund, at a value of -7% from the week before . To me that is taking advantage of a “market opportunity” so I would say it is indeed “market timing”. I would not have made that purchase a month ago.

    However, I did so with two considerations (1) The fund was already a core holding, and (2) I added to the max percentage I would invest in that fund. So it is also “rebalancing” as you suggest. I also added to my Dividend Stock core holdings for exactly the same reasons.

  4. Canadian Couch Potato June 24, 2011 at 10:43 am #

    @Ninja: The kind of thing you describe sounds perfectly fine. You had some money to invest and you added it to a core holding that had recently declined in value, and you didn’t exceed your long-term target allocation. This is clearly better than not adding the money at all, isn’t it? :)

    Where I see the biggest potential for problems is when people sit in cash for long periods because they think something is overvalued, or they make frequent tactical shifts because they think something else is undervalued. They are assuming that their assessment of value is somehow superior to the market’s.

  5. gilbert June 24, 2011 at 11:00 am #

    Call me a market timer.

    However I did use the 50 DMA, 100DMA & 200DMA.

    The Death Cross of August 2008 when the 50 DMA cross the 100 DMA & 200 DMA saved me from a world of Hurt.

    I also used the Golden Cross of May 2009 to re-enter the Stock market speed up the Recovery & Profit .

    The 50% Bond position also added to the protection of the Portfolio.

    However do rebalanced It forces you to Buy Low & Sell High to Prosper.

  6. Canadian Couch Potato June 24, 2011 at 7:46 pm #

    @gilbert: I have heard other technical analysts claim they were able to predict the crash of 2008, but I don’t understand how moving averages or any other market data could have predicted events like the bankruptcy of Lehman, or other specific events that set off the cascade of panic we saw in the fall of 2008. To suggest that past data has predictive value is hard to accept. Your timing was extremely fortunate in 2008-09, but with all due respect, it sounds like luck.

    I happened to rebalance my portfolio in February 2009, a couple of weeks before the turnaround, and did extremely well as a result. But I am the first to admit the timing was fluke. I just did it because rebalancing is part of my long-term strategy.

    It’s interesting that you mention you also keep about 50% in bonds. I would expect that keeping this allocation and rebalancing regularly would be more likely to produce better long-term results than making big moves based on technical buy and sell signals.

  7. Jon Evan June 24, 2011 at 11:15 pm #

    @Couch potato asks: “Can you enhance your returns by identifying the right time to buy?” Would not a better question be to ask should you protect your capital by identifying the wrong time to buy. The mistake I made early on was that I was too focused on return on capital rather than return of capital. All would agree that investment success is all to do with compounding and that the power of compounding works best on capital in the early years rather than later in life and so protection of capital is strategically important. Would I buy now with the TSX composite index at ~14000 a place it was just before the 2009 crash or would I protect my capital and move it to safer assets as a long term strategic move? Even John Bogle seems to warm to the idea of valuation-informed index investing as a long term strategy to protect capital and that knowing when to lower or increase one’s stock allocation might not be quite as difficult as it seems. I would agree that short term tactical timing of the market is wrong but unless one believes the TSX composite index will be 30,000 in ten years intuitively it seems rational to move to protect one’s capital in times when the stock market is ridiculously high in the context of an indebted world?

  8. Canadian Couch Potato June 25, 2011 at 9:01 am #

    @Jon Evan: Certainly it makes sense to dial down the risk in one’s portfolio later in life to protect wealth. That’s a basic tenet of asset allocation strategies. If market volatility makes you nervous, then you should take whatever steps necessary to build a portfolio that matches your needs and comfort level.

    However, I just don’t understand how anyone can say with confidence that a whole market is overvalued or undervalued. You argue that the TSX Composite is “ridiculously high” now, yet it is below 13,000, down from 15,000 three years ago. What do you feel is its fair value, and how do arrive at that figure?

    I don’t know where the 30,000 figure came from, but to reach that point in 10 years, the TSX would have to compound at 8.7% annually. That would not be out of line with historical returns, though I think most financial planners would recommend a more conservative estimate. Over the very the long-term, the expected returns on stocks should be in the neighbourhood of 5% + inflation. The only guarantee, however, is that there will be lots of volatility along the way.

  9. Jon Evan June 25, 2011 at 2:40 pm #

    @ Couch Potato Thank-you for your reply. I appreciate your insights as I’m trying to process all of this! My commenting clumsiness I think has caused you to miss the forest for the trees in my post. The numbers are fictional to try to make my point that markets can become overvalued as in the dotcom boom of the 90′s and the US housing bubble which followed. How you can say that: “I just don’t understand how anyone can say with confidence that a whole market is overvalued or undervalued.” is hard for me to understand since even Greenspan mused about the “irrational exuberance” of the dotcom overvalued market and people like Robert Shiller predicted the US housing bubble crash and a crash can bring down the “whole market”. So my point is that I think one can see signs of an overvalued market and perhaps it is rational to move out of equities to protect one’s portfolio capital and I mean out completely as a long term strategic move to protect capital. I know this goes against passive investing theory but being overly dogmatic is also risky. You say that: “Over the very the long-term, the expected returns on stocks should be in the neighbourhood of 5% + inflation.”, but this is equally fanciful to me and takes great faith because it is based on cyclical historic data. Personally, I don’t have that kind of faith that the future will always be predicted by the past and I fear that future market behavior may be vastly different than what models would predict with the global sovereign debt of seismic proportion changing everything!

  10. Canadian Couch Potato June 25, 2011 at 3:20 pm #

    @Jon Evan: I don’t mean to suggest that markets are always fairly valued, only that we have no way of knowing what “fairly valued” means. This is the basis of the efficient markets hypothesis, which is often misunderstood. It does not mean “prices always reflect the true value of an asset perfectly.” It means “the best estimate of an asset’s true value is the market price.”

    Note that Greenspan made his “irrational exuberance” comment in 1996. Over the next three years, the S&P 500 returned 31%, 27% and 20%. Had you agreed with his assessment and gotten out of the market at that time, you would have missed one of the best three-year runs in history. The point is not that Greenspan was wrong. It was that the market took three years to agree with him, and that is all that mattered to investors.

    Of course, if you stayed in the market through 2000–02, you would have back most of what you earned, and then from 2003–06 we experienced another huge bull market, which also ended in catastrophe. How could an investor possibly have known when to get out and when to get back in during this period?

    An asset allocation strategy tries to address this uncertainty by diversifying globally and across several asset classes (including fixed income). During roaring bull markets, the strategy calls for taking profits occasionally, but always according to a rebalancing schedule. It’s not perfect, and it won’t protect you from losses, but it’s better than making decisions based on emotion and intuition.

    As for the long-term expected return of stocks, we of course cannot know this with any certainty. But 100+ years of global data is the best we can do. We need to try to remember that the times we live in are not unique. Try to picture yourself as an investor in the Depression, or during World War II, or the McCarthy years when capitalism was doomed, or the stagflation of the 1970s (remember The Death of Equities?), or the fear that Japan would become the world’s economic powerhouse in the 1980s, or the Asian contagion and Russian default of the 1990s. You get my idea. There have been very few periods in history when investors have said, “Gee, everything’s looking really great and I’m not at all worried about investing.” Indeed, that would be the absolute worst time to invest. :)

    This time is not different, except in the details. I feel the best course is always to determine how much or how little risk you need to take, and then turn off BNN and stick to the plan.

  11. Jon Evan June 25, 2011 at 5:25 pm #

    @ Couch Potato
    But I did liked Greenspan (I heard back then he only invested in treasury bills!) and got out because I was uncomfortable and no I didn’t get 31% on my equities but I did make 15% (and I was happy with that) but it was easy to stay out then because interest rates were 4-5% and it was even easier to stay out then because fixed income was quite attractive with interest rates climbing until 2002. But then interest rates fell and fixed income became unattractive but the market was rising and it was intuitively rational to get back in and so I did. But by 2006 the TSX had gone up significantly and Robert Shiller second edition was warning about the US housing bubble and again I was uncomfortable. It was easy to get out in 2006 because interest rates had gone up again when GICs were again respectable and so I got out and again I didn’t lose my capital. Things are similar but different now. What is the same is that the TSX is up again but what is different is that interest rates are down too! That is different because it is difficult to feel good about fixed income and so more money I think is flowing into the stock market. This is making me uncomfortable again and I got out in April. You have great faith in passive investing and I respect your faith. I cannot turn off BNN (sad to say) nor stop reading. I may be totally wrong and end up a pauper when in ten years inflation hits 10%. I’ll post then that I should have listened to you! :) Have a good weekend and keep up the good blog.

  12. Canadian Couch Potato June 25, 2011 at 6:11 pm #

    @Jon Evan: Thanks, it’s a fun debate! Enjoy your weekend.

    I can’t stop reading about this stuff either, but the more I read, the more I realize that forecasts are worse than useless. I think we’re reading different things. :) You might like Alexander Green’s The Gone Fishin’ Portfolio:
    http://www.gonefishinportfolio.com

  13. Chris June 26, 2011 at 1:15 am #

    @JonEvan: It sounds like you’re doing more than just market timing… you’re doing tactical asset allocation (shifting percentages of your investments back and forth between fixed income and stocks based on your perceptions of the market). It’s essentially a very active strategy. Historically, these strategies have not outperformed the market. So, while I definitely understand your point that historical returns are not guaranteed into the future, it’s also worth considering whether historical evidence suggests that your strategy might outperform the market in the future.

    Assessing the state of the market is harder than it seems. Few people would have predicted that bonds would outperform stocks for a whole decade. People keep predicting that the bond run is over and that rates will rise, but while interest rate rises keep being predicted, now there’s talk they won’t rise (in the US at least) until 2013. Plenty of people got caught out getting out of the bond market too early. Also, part of the difficulty with your approach is also that it becomes very difficult with more than two asset classes. Except for the catastrophic bears, no one would have predicted that gold would have been the #1 investment of the last decade and that the right move was to get in and stay in. It seemed overvalued for me since at least 2003. When would have been the right time to shift from fixed income and stocks into gold or commodities? Who knew US REITs would do so well (after the bust) even though the housing markets there are still falling and there are still serious problems with commercial real estate? With a diversified portfolio, market timing just gets harder and harder.

    That said, if you’re not comfortable with the idea of efficient markets or traditional indexing, you should definitely consider fundamental indexes (PRF, PRFZ, etc.). These products take advantage of market inefficiency.

  14. Jon Evan June 26, 2011 at 11:21 pm #

    @Chris thank-you for your comment :)
    Indeed, you are correct Chris that I’m not a fan of the efficient market hypothesis to which Couch Potato subscribes. He says it’s because I read different books and he is likely right! If you read Justin Fox’s book ‘The Myth of the Rational Market’ you will understand me. Now I love Couch Potato’s model portfolios. They are appealing to me because of their simplicity unlike all the work I have to do :(. But, they are based upon modern portfolio theory wherein the efficient market part I intuitively find very hard to agree with. I don’t believe that market prices follow random probability theory but believe that extremes can haphazardly happen because of human ill behaviour and that I must be involved to look out for signs of impending doom in order to protect my capital.
    You miss my strategy for it is not to outperform the market but the simple strategy to look out for my capital rather than leave it to chance. Therefore, profit taking and buying equities when undervalued has been, as I describe above, what I have been doing for several decades. Perhaps I’m neurotic as behavioural finance theory would suggest but you have to follow your heart because you are human :)!

  15. Chris June 27, 2011 at 12:45 am #

    @JonEvan: You don’t necessarily have to accept the EMH or the CAPM to follow MPT. (Harry Markowitz, one of the major developers of MPT, is actually ambivalent about the EMH and the CAPM.) I agree with you; the evidence is fairly overwhelming that the EMH does not hold except in a weak form that is essentially tautological.

    However, markets are fairly efficient on average (some more than others), which is why indexing tends to work. And they’re also usually sufficiently efficient to make it difficult for active management to actually beat the index over any extended period of time.

    I think you’d really love the book “The Fundamental Index: A Better Way to Invest”, by Robert Arnott, Jason Hsu and John West (Wiley, 2007). It spends quite a lot of time revisiting/questioning many of the assumptions behind indexing. It’s one of the Couch Potato’s recommended books, actually.

  16. Patrick July 13, 2011 at 5:40 pm #

    @Chris: do you have a link to evidence that the efficient market hypothesis does not hold?

  17. Andrew F July 15, 2011 at 10:00 pm #

    CCP: Have you read any of the work that Mebane Faber has put out about using a very simple, mechanical timing system to trigger buy/sell decisions? He uses a 10 month total return simple moving average in the research, though the results are stable across 6 month – 12 month moving averages.

    One of the reasons this might be compelling for investors is that down markets are very psychologically difficult for many investors. Not selling despite earlier warning signs exposes investors to the risk of making poor decisions, such as selling at the trough.

    His research indicates that a diversified portfolio of asset classes using simple timing can reduce portfolio volatility, if not add much to return.

    If you’re interested, google ‘A Quantitative Approach to Tactical Asset Allocation’.

  18. Dan September 9, 2012 at 2:00 pm #

    Hi I am a new reader, and so please excuse what may be an ignorant question. You say that all markets are mean reverting, eventually, and cite the example of the 1970 to 2010 period in which all developed markets returned very similar numbers. Over that period, and maybe even longer, I am sure I cannot argue.

    But isn’t that argument fundamentally flawed when we step back and view greater periods of time? I am not talking 40 or 50 years but hundreds. In fact, wouldn’t it be true that virtually no market (that I can think of) has ever been mean reverting over long periods? The history of stocks and markets goes back to 1600odd Holland, when the NYSE or USA foe that matter didn’t even exist. Clearly a dollar invested in 1600 Holland or 1800 england does not have the same value as a portfolio invested in the USA for the past hundred years. Or does it?

    I guess my point is – isn’t there necessarily some truth to the “you have to account for macroeconomics” argument, and some necessary fallacy in the mean reverting argument, when we have seen the literal rise and fall of multiple nations/cultures/markets in hrs past 500 years alone?

    I agree 100 percent that I am not smart enough to know when those are going to happen again, so maybe there is no better course anyway. But shouldn’t we at least acknowledge that seismic shifts not only can but most likely will happen again?

  19. Canadian Couch Potato September 9, 2012 at 4:46 pm #

    @Dan: Welcome to the blog, and thanks for the question. If you were to fast-forward a century or two from today, obviously not all stock markets will have fared the same. As you suggest, some countries (and their markets) will no longer exist. But you cannot possibly know which ones.

    It seems highly likely that if you $1 invested in the United States, $1 in Canada, and $1 internationally today those amounts will be identical in a hundred years. The point is that the expected returns of these three markets are essentially the same: they all have approximately the same level of risk and potential reward. Since you cannot know what the future holds, the best investment choice is to spread your risk around by diversifying. The reader’s original question suggested you could improve returns by trying to pick future outperformers based on technical indicators. I don’t think this is reliable.

  20. TJ May 4, 2013 at 9:22 am #

    Comparing the annual returns for the last 10 years,
    Gone Fishin Porfolio’s: 10% per year
    Complete Couch Potato: 7.5% per year

    Can the rise in the Canadian dollar alone account for this large discrepancy? I’m aware that fees are higher on Canadian index funds, but even with the rise in the dollar I didn’t expect the difference in performance to be this high. Should I consider using a US$ RRSP if the returns are this different?

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