Should You “Buy & Hold” or “Time” the Market?

Warren Buffett likes to counsel individual investors to buy-and-hold (specifically, buy an equity index fund and hold it forever). This is a perfect example of “do as I say, not as I do,” as Buffett has successfully timed the market for decades and, [interestingly,] Buffett is now carrying his largest cash position ever in stark contrast to individual investors who now hold their smallest cash positions since the height of the internet bubble. Clearly, he’s timing once again and I’m sure a few of you are wondering just how he manages to do this so successfully. [Let me explain.]

By Jesse Felder (thefelderreport.com). Originally posted* under the title How To Time The Market Like Warren Buffett.

…Warren Buffett’s investment philosophy [is put forth] in the Berkshire Hathaway Chairman’s Letter of 1992 in which he wrote:

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase…  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable:  When bonds are calculated to be the more attractive investment, they should be bought.”

In other words, ‘when stocks are better value buy them. When bonds are the better value buy them.’ Couldn’t be simpler; could it, but how does Buffett calculate “value?” In the quote above he references “discounted-flows-of-cash,” a very complicated valuation model that relies on many assumptions that can cause all sorts of problems. I think there’s actually a much easier way to look at it.

Back in 1999, when he decided to market-time the internet bubble (well done, sir), Buffett hinted at his process telling Fortune, “I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17”, so what tool does he use to make a “persuasive case?” A couple years later, once again via Fortune, he revealed it: the ratio of total stock market capitalization-to-GNP (or GDP), calling it, “probably the best single measure of where valuations stand at any given moment.”

Okay, but HOW does he use it? Here’s my best guess: John Hussman has done some work with this indicator and found that it is very closely correlated to future returns in the stock market. In other words, this indicator is very good a predicting future returns for stocks over the coming decade.

When Buffett said in 1999 that the next 17 years were very unlikely to look like the prior 17, he meant that:

• the starting valuation in 1982 was so attractive (based on his favorite yardstick, market cap-to-GDP, which stood at 0.333) it virtually guaranteed wonderful returns over the coming decade and, conversely,
• the starting valuation in 1999 was so unattractive (based on the same yardstick reading of 1.536, or 4.5 times higher than the 1982 reading) it virtually guaranteed horrible returns.

[As such,] I believe Buffett very clearly understands the predictive ability of his favorite yardstick and he uses it to time the market by comparing future stock returns to future bond returns, as he said in the quote from the 1992 letter above. Stay with me here.

[Here’s what I did:]

• I ran the numbers on Buffett’s yardstick and its predictive ability myself, using the data from FRED and Robert Shiller covering the years from 1950 to 2013, and found it to be negatively correlated (low values correlate with better 10-year returns and vice versa) by over 80%.
• I then created a forecasting model based on the data which tells us what stock market future annualized returns should be over the coming decade based upon the current reading of the yardstick…
• [I then took the generated number] and simply compared it to the current yield on the 10-year Treasury note to see which offered the best return over the coming decade, just as Buffett prescribes, that is,
  • when stocks offer a better return, they should be bought and, conversely,
  • when the 10-year treasury offers a better return it should be bought. Simple.

[Below you can see]…what would have happened if someone had followed this model, only looking at it once a year at year-end, starting back in 1950…

They would have:

• owned stocks from 1950 to 1981,
• switched into treasuries for only a year.
• owned stocks again from that point until 1996 when bonds offered the greater prospective return,
• stayed out of stocks for nearly the next decade (through the rise and fall of the internet bubble),
• sold their bonds in January 2003,
• bought stocks again…for [a period of] two years and then
• switched into bonds again in 2005
• bought stocks again until January 2009, after the heart of the financial crisis had already passed and stocks were once again attractively valued relative to bonds, then
• switched into treasuries again at the end of 2012 and
• still hold those treasuries today.

How did…[the hypothetical investor] do? Even after missing the massive gains of the internet bubble and those we saw in stocks over the years, [see chart below] this hypothetical Warren Buffett-wannabe-market-timer…[would have seen]:

• $1,000 grow to roughly $1.15 million today
• compared to $720k for the buy-and-hold investor and
• a mere $32k for the all-bonds guy.

All the hypothetical investor did was buy stocks when they were more attractive; otherwise bought bonds. Simple.

Conclusion

This model is merely for educational purposes – it doesn’t factor in transaction costs or taxes (which could be huge) – so it’s not in any way a recommendation for you to use with your investments…[That being said,] it’s definitely something to consider when evaluating investment opportunities on a broad basis or deciding where to put new money to work.

[The above article is presented by  Lorimer Wilson, editor of  www.munKNEE.com and www.FinancialArticleSummariesToday.com and the FREE Market Intelligence Report newsletter (sample here) and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. This paragraph must be included in any article re-posting to avoid copyright infringement.]

*http://thefelderreport.com/2014/08/07/how-to-time-the-market-like-warren-buffett/

Stay connected!

• Register for our Newsletter (sample here)
• Find us on Facebook
• Follow us on Twitter (#munknee)
• Subscribe via RSS

Related Articles:

1. Is “Buy & Hold” the Way to Go?

2. Buy, Hold or Sell? Time the Market By Watching Change In Market Trends! Here’s How