The long-awaited market correction finally came last week. The question we'll try to answer is: Would investors have done better waiting for a dip or a crash before entering the market, especially when prices are deemed high; or are you better off deploying your money into the market as soon as you have it?
Consider this friend of mine who, back in late 2013, said to me: "I'm staying out of the market. A crash is coming! I can feel it in my bones!"
In the four years till the end of last year, the Dow Jones Industrial Average had gone up by 58 per cent. With dividends reinvested, it's a whopping 74 per cent in Singapore dollar terms. The Singapore market had done more modestly - at 7 per cent in that time, or a more decent 23 per cent with dividends reinvested.
In contrast, there's another friend who knew of someone who said he would jump into the market only when there is a crash. He would then cash out when the market recovered. Most of the time, he'd be sitting on cash waiting for the next big crash to come. According to him, he hadn't done too badly for himself.
To find the answer, we at Inclusif did a study.
WAITING FOR A CRASH DOESN'T PAY
We looked back over the past 30 years in the Straits Times Index (STI). We came up with eight trading strategies. Each strategy has a combination of buy and sell triggers. The buy triggers range from a 10 per cent to 25 per cent market correction, and the sell triggers range from a recovery of 20 per cent to 50 per cent from the point of entry.
During the 30-year period, the STI - with dividends reinvested - yielded a 7.9 per cent compounded annual return.
Of the eight strategies, only one outperformed the buy-and-hold strategy, and only marginally at that. The strategy of buying after a 20 per cent market correction from the preceding nine-month peak, and selling after a 50 per cent increase from that entry level generated a return of 8.2 per cent per annum over the last 30 years. The rest of the seven strategies underperformed the strategy of being fully invested in the market throughout the whole 30 years. Monthly data is used for this study.
Hence the conclusion is: Waiting for a correction before entering the market mostly fared worse than a buy-and-hold strategy.
Below are our observations from the study:
• The buy and sell thresholds are arbitrarily set and have no bearings on the fundamentals of the market. Each cycle may be different and results may differ slightly if, say, daily or weekly data is used;
• But generally, if you define the crash threshold too loosely (say, a drop of 10 per cent), you are likely to suffer further drawdowns - that is, the market is likely to continue to decline, after you enter the market;
• If you define the crash threshold too stringently (say, a drop of 25 per cent), you stay out of the markets for the most part, which is bad because long-run equity returns are positive. This is what happened in Plan F. The correction in 2015/2016 did not hit 25 per cent, so the buy threshold was not reached. As a result, that portfolio has stayed in cash since May 2013. Consequently, it missed out on a total return of 12.5 per cent from then until the end of last year.
• If you define the recovery threshold too loosely (say, up 20 per cent), you exit the equities market too quickly, which is bad because long-run equity returns are positive.
• If you define the recovery threshold too stringently (say, up 50 per cent), you pretty much get returns that are quite similar to a buy-and-hold strategy, since you will stay invested for a long time once you enter.
THERE IS A COST TO WAITING
Recently, we came across a study which drew the same conclusion - that it does not pay to wait for a stock market correction.
The research, done by Elm Partners, a London-based asset management firm, tried to find out: At times when the market has been expensive, what has been the average cost or benefit of waiting for a correction of 10 per cent from the starting price level before entering the market, rather than investing right away?
It used US market data over the past 115 years and defined expensive as times when the stock market had a cyclically adjusted price-earnings ratio or CAPE that was more than one standard deviation above its historical average level. The waiting period is three years.
They found that:
• From a given expensive starting point, there was a 56 per cent probability that the market had a 10 per cent correction within three years, waiting for which would result in about a 10 per cent return benefit versus having invested right away.
• However, in the 44 per cent of cases where the correction doesn't happen, there's an average opportunity cost of about 30 per cent - much higher than the average benefit.
• Putting these together, the mean expected cost of waiting for a correction was about 8 per cent versus investing right away.
Put in simpler terms, it means that while we may reasonably expect a correction to happen some time in the future, we don't know when for sure. When the correction doesn't happen for some time, some investors may get pushed to invest at higher prices. And when the correction finally happens, it may be from a significantly higher level from today. The after-correction level could still be higher than the level today, in which case, investors would have missed out on that return.
It is well documented that we humans tend to underestimate opportunity costs relative to realised costs. As with my friend at the beginning of this article, he would have suffered significant opportunity cost had he stayed out of the market for the past four years or so.
Elm Partners then did a sensitivity analysis, allowing the entry levels to range from 1 per cent correction onwards to 10 per cent, and reducing the waiting time to one year and increasing it up to five years.
What they found was that across all scenarios, there has been a material cost to waiting. The longer the horizon that an investor has been willing to wait for the correction to occur, or the bigger the correction for which they are waiting, the higher the average cost.
If you believe the stock market has a negative expected return to a particular horizon, then waiting for a correction to invest makes sense, said Elm Partners.
However, at least as far as the historical record for the US stock market goes, and quite similarly for other markets, higher market valuations are consistent with lower prospective long-term returns, but not negative expected returns.
• The writer is the portfolio manager of Inclusif Value Fund, a no-management-fee Asia-Pacific value fund (www.inclusif.com.sg).