How to Use Valuation Analysis to “Time the Market”

There are many approaches investors use to “time the market”. However only valuation analysis has been proven to work in the long run. We’re going to explore how and why valuation analysis is the best approach to determine your asset allocation.

Time the Market Discussion 

Momentum investors time the market based on technical indicators. Many will use charts, trends, moving averages, cycle theory, etc. to time the market.

I have no problem with using technical analysis in partnership with fundamental analysis. It makes sense to use every tool we have available to lower risk. However, technical analysis without fundamental analysis is just speculation, not sound investing.

The buy and hold strategy advocates claim you can’t time the market. They argue that many investors crash and burn trying to time the market (which is true!).

Although many of their arguments are valid, I contend that most are doing it incorrectly. Any good financial concept can produce poor results if done improperly.

Regular readers of the AAAMP Value Blog know I put an  emphasis on the fact that price matters! Investment decisions should be made with valuation the primary factor. That is a form of market timing I call valuation analysis timing. 

Is it possible to successfully use valuation analysis timing to consistently time the market over short term time periods such a weeks, months or even a few years?  Absolutely NOT.  This is not the kind of market timing I would advocate.

The longer your target time period the greater your probability is to successfully time the market (through valuation analysis). I realize this is the major hinderance to value investing. Many investors want instant gratification and lack discipline to think and enact long term strategies. They want to “trade” their way to prosperity. Most of these investors eventually make behavioral errors that cause large drawdowns.

Others choose a true buy and hold strategy and plan to “never sell” securities even when they become significantly overvalued. This might work well if you have the one in a million ability to pick the right stocks early enough. 

Warren Buffett is heavily mentioned and followed for this strategy. However this is a fallacy. First of all it’s a misnomer that Buffett never sells. He has and does. He has a very small number of core stocks he has held for decades. Otherwise he has exited many positions over the years. Secondly, Buffett is a huge proponent of valuation analysis and even endorsed one of the valuation tools we will look at later. In addition, very few of us (one in a billion) have the abilities and/or circumstances of a Warren Buffett.

As a value investor you want to have the patience to wait for favorable prices to buy.  Conversely, you want the discipline to exit positions which become overvalued and no longer offer prices that offer a favorable risk/reward relationship.

The reason for this kind of investing is it greatly reduces your risk. Risk management is the key to successful long term investing.

Instead of predicting what the market will do in the short term, a value strategy involves valuation analysis timing based on fundamental analysis to determine the risks and opportunities for reward based on price.

Stock Market Valuation Analysis

The goal of value investing is to purchase assets that are selling below their real worth. In other words, we want a purchase price that offers a margin of safety. The reason we do this is because it lowers risk and greatly increases the chances of a profitable outcome.

When market valuations are low the value investor should take advantage of the improved probability of higher prices by increasing portfolio allocation to equities. When market valuations are high the value investor should lower risk by decreasing portfolio allocation to equities. This lowers the probability of large portfolio drawdowns.

Now the million dollar question: How do you determine when the stock market valuations are low or high? 

Keep in mind, there is no need to be precise here. This does not call for a formula that provides an exact answer. The following metrics will provide a general perception of whether the market is a bargain, expensive, or somewhere in between.

Here are 4 excellent metrics for your valuation analysis:

S&P 500 Price/Earnings Ratio

S&P 500 Price to Sales Ratio 

Current Shiller PE10 

Total Market Cap Relative to Gross National Product

The S&P 500 PE Ratio tells you how much you are paying (price) for $1 of earnings. The long term average is approximately 16 which equates into a 6.25% Earnings Yield (1 dividend by 16 = 0.0625).

The S&P 500 Price to Sales Ratio tells you how much you are paying for $1 of sales.  The long term average is approximately 1.5.

The Shiller PE10 is a long term earnings based metric. It smoothes the volatility of earnings over a 10 year period and compares it to the current price. Historical data has shown a high inverse correlation between the index and returns over a 20 year period. The long term average Shiller PE10 is approximately 17.

Total Market Cap Relative to Gross National Product is often called the “Buffett Indicator” because he has called it his all-time favorite valuation indicator.

This ratio measures the value of the stock market compared to the economy. It makes sense that these two metrics would move together in the long run and historically they have. Long term returns have been inversely correlated with the ratio and provide a historical probability of future long term returns at the current valuation.

The long term average ratio has been approximately 70%. The higher the valuation the lower the expected future return (higher risk). The lower the valuation the higher the expected future return (lower risk).

These are “Key Market Statistics” that are updated frequently for members of my premium Arbor Investment Planner Newsletters .

Valuation Analysis Timing Put Into Practice

The stock market has earned an average of a little less than 10% per year in the long run. But the average investors actual returns are nearly 4 percentage points lower because people tend to buy when prices are high and tend to sell when prices are low. 

There is a behavior gap that affects investment returns. Instead of market timing based on valuation many let their emotions cause them to make detrimental asset allocation decisions.

Undervaluation and overvaluation are usually caused by a misjudgment of perceived risk vs. real risk. When investors get overly pessimistic they perceive the risk to be much greater than it really is. This causes prices to fall and create bargains. Conversely, when investors get overly optimistic they perceive risks to be less than reality. This causes prices to rise above the real value of the asset.

Summary

Trying to predict whether the market is going up or down in the short term is a bad approach to time the market. The best approach is to improve the probability of an above average return by purchasing assets that are priced below their real or intrinsic value.

Valuation analysis timing is a completely different longer term way of thinking about how to time the market. Improve the probability of above average rates of return by increasing your asset allocation to investments whose valuations are bargains. Decrease the risk of portfolio drawdowns by decreasing your asset allocation to investments whose valuations are significantly overvalued.

Related Reading:

5 Portfolio Risk Management Strategies

Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.