Blessed by the Potato

In the Globe, a defence of market timing. An interesting dilemma, because I tend to say that timing is bad, and is so extremely hard to do that it’s not worth attempting. But value investing is good, and is one of the few time-tested ways of improving your returns. Yet if value investing is “buying when a stock is cheap” then where is the distinction between that and timing?

Market-timing, he insists, is nothing more than a way to lower portfolio risk. “If I show you an asset class that’s overvalued by any definition, and if you sell that security to buy one that we all agree is undervalued, is that a risk-reducing strategy or a risk-increasing strategy?” he routinely asks investment audiences. They always acknowledge it reduces risk, he says. “But if you do that you become a market-timer, because you won’t know when you’re at the top or when you’re at the bottom. You’ll have to make your best guess. … Any transaction that involves trying to enhance the value of your portfolio is a market-timing transaction. We should all stand up and applaud [it]. Yet it’s still one of the most vilified terms in the investment business.”

I suppose I have to agree with most of that. For example, I consider Toronto real estate to be “an asset class that’s overvalued by any definition” and I’ve avoided it. But the timing part is still hard: it could remain stupidly valued for years more to come.

“The fact that stocks, on average, deliver a 7-per-cent premium over inflation is a meaningless statistic. Just ask anyone who retired in the year 2000,” says Mr. Solow…

Though that I’d disagree with: it’s not a meaningless statistic. On average, they have, over decent time periods. Someone who retired in 2000 has had fairly mediocre returns since then, but had phenomenal returns leading up to that point (when they would have been in their asset allocation years). Indeed, understanding what average long-term return can be expected is one way of determining under- or over-valuation, if you believe in mean reversion.

One example is my own: I got the timing fairly wrong in the crash (too early), but did recognize that stocks were getting cheap, so I loaded up, and had shifted to 100% equities by October 2008. Then recently, Wayfare and I were discussing whether we should continue to be essentially 100% stocks. I updated this graph, and figured that, despite the massive returns we’ve seen over the last two years, things didn’t look terribly over-priced (certainly not cheap, and not generationally-cheap, but not pricey), so my thoughts were that going forward stocks should still outperform bonds, and, except for cash needed for safety and transactional needs, we should continue to keep it all in equities.

On another note, Bronte Capital discusses the current state of the market: basically, not pricey, but not cheap, which fits with my own general take on things. There is some lamenting that private equity firms have gobbled up all the bargain small caps, so that the companies that are still public are either expensive, or in some way less desirable. That would suggest that private equity has disrupted the normal state of things, where small caps offer a premium for the risk they present. This may be a bad time to put a small cap tilt to your asset allocation. However, I wouldn’t take that as gospel: private equity, leveraged buy-outs, etc., have been around since the 80’s, and small caps still seemed to do well relative to large caps even through the 90’s and 00’s (they did very well relative to large caps in the 80’s, but that’s to be expected if that’s when private equity really expanded and started bidding them up).