As a smart consumer waits for the product they plan to purchase to go on sale, so a smart investor should wait for the proper entry price and valuation to add an investment to their portfolio.
An interesting study, completed by Barclays, using the S&P 500 Index (data back to 1988) looks at the subsequent 12-month returns an investor received if he/she invested at varying forward price-to-earnings (PE) ratios. The forward PE ratio is calculated by taking the price of the S&P 500 divided by the expected earnings of those companies.
As one may surmise, the more “on sale” (lower PE ratio) an investor purchased an investment, the better the 12-month average forward returns achieved. For example, if an investor purchased the S&P while it was trading at a forward PE ratio of 15x or less, the subsequent 12-month average returns ranged from +10% to about +30%. If the purchase was made while the forward PE was 19x or greater, the average returns ranged from about +10% to -11%.
Assessing valuation is a critical tool to moderate equity allocations and should not be considered “market timing”. Experts have long opined that investors can’t time the market. Supported by reams of data, their conclusion is demonstrated by hypothetical purchases that miss the worst days or best days and ultimately illustrate inferior returns compared to an investor that simply bought the market or stayed the course. For example, if an investor bought $10,000 worth of the S&P 500 Index and held it from 1996 through 2015, his/her investment would have been worth $48,249 at the end of 2015, achieving an 8.19% annualized return.
However, let’s say that same investor got nervous and started to trade in and out of their S&P investment and happen to miss the best 5 performance days out of this 20 year (5,036 trading day) period. This investor would be left with $32,009, have an annual return of 5.99% and experience a 42.26% reduction in their gross profit than if they remained in the market during each trading day.
It’s unbelievable how a 5 day period can have such a drastic effect on return…right? Now let’s say that same investor missed the best 40 days over that same period. In this case, their initial $10,000 investment would only be worth $6,735, a loss of $3,275 and an annualized return of -1.96%1. These are obviously extreme examples but do clearly illustrate that timing the market can wreak havoc on long-term performance.
But is “timing the market” the same as buying or selling the market when one believes valuations are reasonable or overpriced? We don’t think so and believe the application of disciplined strategies can achieve superior returns over a full market cycle. After all, equity portfolio managers often select a stock based on valuation factors and future earnings. In this age of passive indexing, it is important to recognize that an exchange-traded fund based on an index is simply a basket of stocks that has its own aggregated earnings and valuation metrics.
Investors should be cognizant of the valuation they pay for equities. When valuations seem richly priced, it’s okay to dollar cost average in at lower amounts. Similarly, if valuations have gone to extreme levels it’s okay to take profits off the proverbial table. Perhaps this can be viewed as a different way of saying “buy low, sell high”. Valuation discipline is one method to avoid letting emotion drive an investment strategy.
1 Source: “Missing the Best and Worst Days”, Index Fund Advisor, January 26, 2016