Buttonwood

The perils of trying to time the market

In practice, it is surprisingly hard




JESSE LIVERMORE earned his reputation as a talented speculator by pocketing a tidy sum during the Panic of 1907. Mindful that a scarcity of credit and a giddy stockmarket were a dangerous mix, he began to sell stocks short that autumn. When share prices crashed on October 24th, Livermore was up by $1m ($27m in today’s money). He then changed course. He started to buy stocks, which were now a lot cheaper. The market rallied. By the end of the year Livermore had made $3m.

Anyone who has ever invested in stocks has at one time fancied that they can time the market as exquisitely as Livermore did. Very often, they hope that a benchmark of fair value, such as the cyclically-adjusted price-earnings ratio, or CAPE, will be their guide. History shows that when stock prices rise a lot faster than profits—as they did in the 1920s, 1960s and 1990s—they tend subsequently to fall back (see chart). So the market-timer will sell when the CAPE is high and buy them back when it is low.


It seems simple. In practice, it is surprisingly hard to use valuation gauges to time the market. Investors who try often sell far too early. As a consequence, they miss out on some of the richest returns. Selling stocks when everyone is still buying may actually be the easy bit. It is harder to find the nerve to buy stocks when others are selling them in a panic.

The purist view is that market timing is a mug’s game. It says stocks are a random walk: their past indicates nothing about their future path. In the 1980s academics questioned this creed. Since stock prices tend to revert to a mean value, they must be somewhat predictable. They deviate from this fair value only because investors over-react to news. When profits are strong and stocks are rising, there will be keen buyers almost regardless of value. The reverse is true in recessions. This herding—or, if you prefer, this rational pricing of risk—creates the opportunity for market timing.



There is a drawback. What is “cheap” or “dear” is defined by reference to the full history of prices. But an investor active in any period could not have known this in advance. Nor is it obvious at the time whether the CAPE is close to a peak or trough. Without the benefit of hindsight, timing produces disappointing results.

A study in 2017 by Cliff Asness, Antti Ilmanen and Thomas Maloney of AQR Capital Management tested a timing strategy. Their gauge was a rolling 60-year average of the CAPE. When the CAPE was below its historical median—that is, below fair value—the strategy would borrow to buy stocks. When it was above fair value, it would lighten up on stocks in favour of cash. Over the whole period (1900-2015), returns to the market-timing strategy were scarcely better than to a buy-and-hold portfolio with a constant 100% stockholding. And over the latter half (1958-2015), returns were no better at all.

A big failing was that the strategy was under-invested in stocks for too much of the time. The average CAPE has trended upwards since the 1950s. Too often stocks were deemed dear based on historical valuations. Timing works no better in countries other than America. A study in 2013 by three academics, Elroy Dimson, Paul Marsh and Mike Staunton, found no consistent link between valuation and subsequent returns in 23 stockmarkets.

Value is too weak a signal to be much use. But it can be improved upon. The AQR researchers found that combining the value benchmark with a “momentum” signal of the underlying trend in stock prices yields better results. This is intuitive. The problem with value benchmarks is that prices drift away from them for long periods. But a blend of value and momentum represents “value with a catalyst”, as the authors put it.

This strategy is too complex for ordinary investors to profit reliably from it. But there is a simpler form of market timing, which has some empirical support: rebalancing. It requires investors to decide first how they want to divide their investments. It could be, say, an equal split between American and non-American stocks. The precise weights matter less than that they are stuck to. That requires regular rebalancing to restore the original weights. It means shedding assets that have risen a lot in favour of those that have gone up by less.

The virtue of rebalancing is that it is simple. You are less likely to make a costly mistake than if you follow a more complex strategy. The drawback is that you must give up the delusion that you can time it like Livermore. To do what he did takes nerve and a rare feel for markets. You may think you have such talents. You almost certainly don’t.

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Oil Bull Thesis Attacked From All Sides As WTI Falls Below $50

by: HFIR

 

Summary

 

- WTI falls below $50/bbl as the oil bull thesis is attacked from all sides.

- We explain that these two variables cannot co-exist, U.S. oil production growth of 2 mb/d and sub $50 WTI.

- But the crazy thing is even if you assume a stellar U.S. growth figure, the world will still be in undersupply in 2019/2020.

- In the short-term, we can look stupidly wrong on our thesis, but fundamentals will matter. We stand by our numbers.

 

    

Welcome to the attack from all sides edition of the Oil Market Daily!

 

Since our ill-fated oil article titled, "Brent Breaks $80: The Oil Bull Thesis Enters The 7th Inning," oil bulls went from the White House to the s*** house. The oil bull thesis went from oil demand destruction is the only valid bear thesis to 1) will President Trump keep a lid on prices? Will trade war cause further demand destruction? Will U.S. shale oversupply the world? Will Iranian sanction waivers result in no decline in Iranian crude exports? Will OPEC cut of 1.2 mb/d be enough?

 

It's safe to say there are no shortages of worries in the market according to most market participants. Is it so wrong to assume that the whole market has it wrong on oil prices? No, and we would argue there are valid demand growth concerns, but the point the market is clearly ignoring yet again is that you cannot have these two variables co-exist:

• U.S. shale growth of 2 mb/d and
• Oil prices below $50/bbl.

The reality is that despite the craziness of U.S. oil production growth this year, U.S. shale is still at the whims of the volatility of the oil market. Since cost breakevens were already cut to a minimum in the last downturn, there won't be any new innovative cost reduction methods this time around. And since servicing cost inflation is already near cycle lows, there won't be any cost cut incentives from suppliers.

 

In addition, U.S. shale producers came into 2019 ill-equipped on hedges for next year making capex budgets extra vulnerable to price weakness.

 

What does this lead to?

 

It leads to U.S. shale potentially disappointing growth on the downside. But here's what's more ridiculous and this is the point we tried to get across in our article, "U.S. Oil Production Likely To Grow 2 Mb/D In 2019 But Crude Quality Issue Will Get Worse."

Even if you pencil in +2 mb/d from U.S. total liquids growth, we still have a supply deficit in 2019.

 

But given the real possibility of U.S. shale at least just stalling in H1 2019, this is what the global supply and demand balance is:

 

 

 

And keep in mind we are using global oil demand growth of ~1.38 mb/d for 2019 and we have global oil demand growth falling y-o-y in Q1 2019 by 1 mb/d.

 

What this ends up being is a market that will be in serious supply issues by the second half of 2019.

 

Now of course, OPEC can surprise to the upside with higher production levels, but low oil prices result in more geopolitical chaos. Libya just announced force majure on its largest field resulting in ~400k b/d of loss supplies. But the oil market took that in strides and pushed prices lower by another 5%.

 

At the end of the day, what we are saying is that yes prices can keep falling for whatever reason that currently grips the market today. But it will eventually have to revert back to fundamentals and the global oil supply/demand outlook for 2019/2020 is that of a market in severe deficit.

 

With the world ever increasingly reliant on U.S. shale to deliver, just a stalled growth outlook for a mere 6-months will cascade into a deeper deficit down the road. This is why U.S. shale will never be a swing producer because prices can impact its growth.

 

So yes, we got the Q4 outlook incredibly, massively, disgustingly wrong, but the fundamental outlook has not changed. And while the oil bull thesis is attacked from all sides, we are standing our ground behind our numbers.