Thinking about market timing?

Key Takeaways:

• Market timing is difficult and not the type of behavior we would encourage for most advisors and investors.
• A historical perspective on how frequently portfolios have lost money may help investors remain invested.
• We also suggest some key considerations to discuss with investors contemplating a move to cash.

In recent weeks, how many times have you fielded the question “Should I be moving to cash?” Or maybe it’s come in the form of a bold (panicked?) statement “I need to move to cash.”

We have certainly seen an uptick in this sentiment accompanying the increase in market volatility since the start of the year.

Skittish investors are eyeing current rates on Guaranteed Investment Certificates (GICs) and thinking “A 3% to 4% return looks pretty attractive relative to a market correction.”

So that begs the question: Are investors best served by abandoning their long-term allocations to move to the safety, but limited return potential of cash? It’s never been easy to correctly time markets—but is this time different?

Let’s put emotions aside for a minute and look at some historical perspective to help investors wrestling with the notion of exiting the market.

What to think about

Before considering a move to cash, investors should assess a few factors:

• How frequently have markets and portfolios turned negative—and stayed negative?
• How confident are you about the “sell” signal and how will it feel if you’re wrong?

It’s true that capital markets produce periods of high volatility and negative results for investors. However, those periods tend to be short-lived and reverse fairly quickly as demonstrated by the calendar year results of Canadian financial markets shown below. This histogram shows that over the last 55 years, a balanced 60% equities/40% fixed income index portfolio has produced negative results in only nine of those years. In other words, a balanced portfolio has had positive results in 46 of the 55 calendar years (84%). And in the case of the most negative years, such as 2008 and 2022, they were followed by strong positive years.

Additionally, over the last 55 years there have only been a few times that negative investor returns stretched beyond 12 months. To attempt to correctly, and consistently, time those narrow windows of negative results is a difficult task.

Click image to enlarge

Source: Morningstar Direct. 60/40 Index Portfolio: 20% Canadian Stocks, 40% Global Stocks and 40% Canadian Bonds. Canadian Stocks: S&P/TSX Composite Index; Global Stocks: MSCI World ex Canada Index; Canadian Bonds: FTSE Canada Long Term Bond Index (1970-1979), FTSE Canada Universe Bond Index (1980-2023). Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

To address the “sure it’s a narrow window, but this is a clear sell signal” argument, let’s review a couple of signals that were “obvious” sell warnings and their eventual outcomes.

In all cases, we will be using U.S. market indices as proxies for global markets.

Market timing signal—Exhibit A: The Global Pandemic

The most recent clear “sell’ signal was the COVID outbreak of early 2020. The global economy shut down and the outlook for stocks turned grim early. The stock market started pulling back in February and by the end of the first quarter, stocks were down more than 20%. With so many unknowns, many fearful investors withdrew and parked cash on the sidelines. Unfortunately, this meant these investors missed much, if not all, of the market bounce off the bottom as stocks rallied by 45% over the last nine months of the year. The year of the COVID outbreak produced a 20%+ stock market return!

How could a one-in-a-hundred years pandemic, which caused historically high unemployment and a global recession, not be a sell signal? It wasn’t, and in fact, the 2020 stock market return of 20+% was followed by a 2021 that produced a return of 25+%. Anyone who interpreted the pandemic as an obvious “sell” signal by removing money from the stock market, missed out on some strong portfolio returns.

Market timing signal—Exhibit B: When Lehman Brothers declared bankruptcy in September 2008

Remember the Great Financial Crisis? At the time, when Lehman Brothers surprisingly declared bankruptcy, that certainly seemed like a sell signal. Or was it?

Investors who experienced the bankruptcy and decided to get out of the market on September 30, 2008, missed out on a 4.4% gain over the following 12 months (ending September 2009). Yes, there was a significant equity market drawdown in that window, but investors who stayed invested profited from the 2009 market rally. Many of the investors who bailed after the Lehman bankruptcy stayed out too long and didn’t benefit from the historic recovery.

Market timing signal—Exhibit C: The inverted yield curve

A market “signal” that occurs more frequently than a global pandemic or a historic economic crisis is an inverted yield curve. This occurrence is mainly associated with predicting an economic recession, but recessions and market corrections tend to go hand-in-hand.

This “signal” sounded five times between 1980 and 2019 and in each case a recession—typically accompanied by a significant equity correction—followed. These recessions have taken place anywhere from five months to 24 months after the curve initially inverts—and even during recessions, markets often experience periods of positive returns that should not be missed.

So, an inverted yield curve may not be an immediate market signal despite its recession warning capability. In fact, actual historical results suggest the inverted yield curve may not give much of a market warning signal at all.

Click image to enlarge

Source: Bloomberg, FTSE
Note: Hypothetical analysis provided for illustrative purposes only.
Diversified Portfolios: Two Index Portfolios Comprised of Russell 1000 Index (R1000), and Bloomberg Barclays U.S. Aggregate Bond Index (AGG); 30% Equity: 30% R1000/70%AGG, 50% Equity: 50% R1000/50% AGG, 70% Equity: 70% R1000/30%AGG

On average, the measured time periods above following inversions have produced positive returns. The first six months have typically produced higher than average results, hardly an indicator to “get out” of the market. Expanding beyond one year generally produces positive stock and bond returns. More conservative allocations do better over three years while more aggressive portfolios do better over five years. This is likely the result of bonds getting an intermediate post-inversion boost as interest rates are lowered to combat economic slowing and stocks retreat due to that same economic slowing. Regardless, the hypothetical index portfolios have appeared to recover quickly and post positive results on average following yield curve inversions.

The Global Pandemic and Lehman Brothers bankruptcy and the inverted yield curve scenarios, all “strong” sell signals, are just two examples that indicate timing cash moves around market or economic events can be difficult. Conditions or events that investors may view as clear “Get Out” signals can be cloudier than you may think.

The bottom line

The recent increase in market volatility has appeared to stir up questions about moving out of the market for the safety of cash. We caution against market timing for most investors because that decision is often not rewarded. If investors ignore this and insist on “doing something” in the face of perceived increasing risk, one idea you could pursue is to convince them to temporarily reduce market exposure.

Reducing their equity allocation by 10% to 20% may provide additional cushion if the market does pull back and still allow for participation if markets snap back quickly or don’t drawdown at all.

One final consideration for those contemplating this path is to document the reasons for getting out and the catalyst for getting back in. These decisions are often driven by emotions and not by a long-term perspective, so having a written plan in place may help improve the odds of success or mitigate the amount of harm made by a bad call.