Market Timing

Still working my way through "The Four Pillars of Investing". I have read it once through and now I'm down to making some notes and trying to see if I've learned anything new.

Bernstein believes that no one can make a sustained profit from timing the market. He believes in the "random walk" theory of how the market works.

He refers to studies that found that stocks/mutual funds that have good returns for a number of years then mean revert and do poorly. So, using past performance to predict future performance is usually wrong. However, at one point in the book, he refers to a study that found that in the short term past performance is a good predictor of future performance.

This short-term prediction data is perhaps what draws the public to the market, like a moth to a flame, during the periodic bubbles. You don't have to be a math expert to see "the correlation".

Over the last few years the stock market has done great. For example, the last year has seen returns in the 20-30 % range for Canada and the US. If you take only that data set (its called data mining), pick short time periods at random, and use them to forecast the future returns, I expect the results would show a high correlation. Hindsight is 20/20.

So here we seem have conflicting realities. Short term data is a good predictor but longer term data is a bad predictor. I guess this means that the farther one gets from the beginning of a bull market the less confidence we can have that it will continue. The market moves from being a "good investment" towards being very speculative (a gamble).

One of the easy ways to measure this phenomenon is to look at P/E ratios for stocks. P/E is often shown on charts. For example, the Royal Bank is near a P/E of 15. Not extreme but not a great investment. Farther afield, looking at Research in Motion (RIM), it now has a P/E of 47. That is considered very speculative by any standard.

The reality is that the stock market changes over time. Sometimes it is a great place to invest but at other times it is like going to the Casino.

As the P/E ratios increase, the probability of a "Black Swan" appearing on the horizon increases.

It's not simple math. The equation changes over time. Maybe P/E or similar measurements needs to be brought into the prediction equation. Maybe it's not just "a random walk". Perhaps it is just a problem yet to be solved.