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Market-Timing Works, But It Mucks Things Up

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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I’m writing this a little bit late -- maybe seven years too late. It was after the financial crisis that “tactical asset allocation” came into vogue. The buzzword, and the idea itself, are still very popular.

Tactical asset allocation is a fancy way of saying market-timing. When you think it’s a bull market, you hold more stocks; when you think it’s a bear market, you hold more cash. Everyone would like to do that, right? You buy when things are going to go up and sell when things are going to go down, and you make a bunch of money.

The trick, of course, is getting the timing right. If you bet that we were still in a bull market in October 2007, you got caught in the crash. But if you bet that the downturn in September 2011 was the start of a bear market, you missed the boom that followed. Of course, you can be cautious or aggressive with market timing -- you can slightly shift your allocations, or you can try to go for the big short. But the greater the potential reward from picking market shifts, the greater the risk.

The interesting questions with regard to tactical asset allocation are: 1) Can it really work for asset managers? 2) Should investors buy into it? And 3) How does it affect the market?

Economists have studied all three of these questions. Surprisingly, the answer is that tactical strategies can work, both for managers and investors, but that in doing so they probably make the market more volatile and inefficient.

Why can tactical strategies work? Because returns in most asset markets are predictable. This was first noticed -- in academia, at least -- by Robert Shiller in the early 1980s, but by now it’s common knowledge. Measures of fundamentals, like dividend yields, predict stock performance. Bond prices are predictable too. When assets look expensive relative to their historical fundamentals, it’s a sign that a bear market is coming. And since lots of other things in the market and the economy are correlated with stock and bond fundamentals, there are any number of signals out there that could give people useful information about how to time the market.

Of course, there are caveats. The predictability is there, but it isn’t very strong -- the boost to returns from market-timing strategies just isn’t that big. It also takes years for the effect to kick in, meaning that if your performance is measured annually, there’s a good chance your far-sightedness won’t be reflected. Still, tactical strategies can boost an asset manager’s returns if used correctly.

There are probably much better ways of doing it than the one described above. Though these strategies are secret, we can see evidence of them in action -- for example, by observing all the hedge fund managers who sold technology stocks right before the bubble burst in 2000.

What about investors, though? Sure, there are managers who can time the market. But can an ordinary investor pick one of the good ones from the bad ones? The intuitive answer is “no.” After all, every buyer has to have a seller, so everyone who makes a successful market-timing trade has to be balanced out by someone who makes a failed market-timing trade. On average, people can’t beat the market. And since investors usually don’t understand the strategies their managers are using, picking a tactical asset manager is basically done at random. Random picking can’t beat the average -- all you’re doing is taking on more risk for no expected return.

But this conventional wisdom -- which is really just the efficient markets hypothesis -- could also be wrong. As economists Brad DeLong, Andrei Shleifer, Larry Summers and Robert Waldmann explained in a landmark paper in 1990, when market-timers all buy and sell in tandem, they can create bull and bear markets out of thin air. This allows them to earn higher returns, on average, than more rational or contrarian asset managers (though they also take on more risk). So if tactical allocators act on the same signals, they could form herds that push market prices up and down, enabling most of them to earn higher average returns. And an investor giving his or her money at random to one of these tactical allocators would also enjoy higher returns, though at the price of higher risk.

The catch here is that this sort of up-and-down movement hurts the market. The tactical strategy I described earlier is based on fundamentals, but the herds described in DeLong, et al.’s paper are acting on signals that have no relation to how much assets are really worth. If tactical allocators make money by pushing the market up and down simply through their collective buying and selling, they are making the market less efficient.

The fundamental-based market-timing strategy described earlier probably only works because an even larger group of market-timers is doing the opposite, creating a giant pack of people who are ignoring fundamentals. Rational, patient investing works because other traders out there are being irrational or impatient.

So while tactical allocation might or might not be a good bet for managers and investors, its effect on financial markets is negative. Managers and investors who ignore the bulls and bears and just focus on fundamentals might miss out on some market-timing opportunities, but they’re making the market work better.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net