Sunday, 22 October 2017

Mean Reversion and Market Timing

For some time I have been a little concerned about the high valuation of equities, particularly in the US. It is just over 12 months since I decided to sell 25% of my Lifestrategy 60 fund. 


In addition I have continued with the selling down of individual shares as well as top-slicing a few of my equity income trusts.  Added to this has been the fall in the value of sterling post the Brexit referendum result in June 2016. This factor alone boosted the value of my Lifestrategy holding by ~12% over the year (and other funds) as they are denominated in US dollars.

Unfortunately, the timing of these sales was probably a little premature - the equity markets have continued to rise and there has not yet been much sign of any sustained recovery in sterling, maybe we will need to await the outcome of the prolonged Brexit negotiations. 

The value of my Lifestrategy 60 fund has increased by a further 7% since last October. In the meantime the sale proceeds remain in cash waiting for a suitable opportunity to reinvest.

VLS 60 past 12 months (click to enlarge)

Reversion to Mean

This is the well-known principle which suggests the price of any particular asset class, however volatile over the shorter periods, will eventually return to its long term average. Here's my post from2014 which describes it in more detail.

The US equity markets have been trading well above their long term average for some time and sterling has been well below its average compared to the US dollar since June 2016. It would therefore be logical to conclude that there will be a correction - the US markets will fall and sterling will rise. The only part of the equation creating a problem is when this will take place. Markets can move against the tide for lengthy periods.

Market Timing

Markets rise and fall so it should be easy to buy low and sell high. When the markets fall back, repeat the process. It sound like a reasonable strategy but in practice, it is very difficult to achieve...in fact, many new to investing do the exact opposite. Therefore the traditional wisdom is to avoid trying to time the purchase/sale of investments but merely buy and hold long term. This is the strategy I try to stick to but I am human and my weakness is a temptation to tinker around the edges.

However, surely if the concept of mean reversion is valid, it should be possible to take advantage of market timing over the same period that an asset class is reverting to its long term average. This is the conclusion of Peter Spiller in his most recent quarterly report (pdf) to shareholders (always a good read).

Spiller has managed the Capital Gearing Trust for 35 years and has a very good track record. I actually added it to my portfolio earlier this year - not for income but as an option to preserve some of the gains made from equity holdings in recent years.
He articulates the case for market timing in a way that intuitively makes sense to my way of thinking and concludes that when the outlook is poor, it is better to hold a reduced weighting to the riskiest assets and wait for better opportunities down the line.

Rebalancing

Of course, the most common way to counter the additional risk to my portfolio from the rising equity element is to rebalance  - sell off the equity gain and redistribute to bonds/cash. This has the effect of ensuring the portfolio remains at a level with which I am comfortable. Indeed one of the great features of the Lifestrategy range is that this aspect is automatically built-in to the fund selected.


Indeed, some of the proceeds from my equity income fund sales and share sales has been reinvested into more cautious funds - the likes of AJ Bell Passive (Moderately Cautious) and CGT.

So the obvious question would be...why did I feel the need to sell a proportion of my VLS fund last October? I think the main driver was the dramatic 20% fall in sterling which artificially boosted the value of my VLS fund. Combined with the fact it was (and still is) the largest single fund by value in my portfolio made me a little unsettled with the prospect of sterling reverting back at some point. Also, the fund holds a large proportion of the US equity market which was trading and continues to trade at all-time highs.

Seeing how things have unfolded over the year, it was probably the wrong thing to do but maybe if I remain patient a little longer it will become a good call.

So maybe my intuitive move to reduce some exposure to equities as the markets have risen over many years combined with a further boost from the fall in sterling can become part of a strategy which offers some flexibility. I am still in the process of thinking this through a little more to try and clarify my own thoughts but feel sure that it should be possible to come up with a formula to compliment a rigid rebalance between equities/bonds/cash - a sort of Rebalance++ option.

As I posted earlier in the year, I'm not suggesting current levels represent the top of the market bull run as I know it is impossible for anyone to predict the top (...or bottom). However, at this point in the cycle, my preference is to hang on to the some of the capital gains accumulated since 2009 rather than stay fully invested in the hope of squeezing out even further gains.

It seems I may have a longer wait than first anticipated before the opportunities present themselves but, unlike the fund managers, I have no responsibilities to other people and I am happy to sit on the cash for as long as needed.


Feel free to comment on the current state of the markets and whether you are concerned about a correction. Are you worried about the lack of progress on Brexit and the real possibility of a no deal?

10 comments:

  1. Thanks for your post DIY.

    Tinkering around the edges was my downfall. I actually switched into VLS 60% pre Brexit and Trump, mostly as I paid too much attention to the media circus and doom mongering that surrounded both events.

    Lesson learned, you cannot time the market IMO. So I switched everything to Vanguard FTSE All World All Cap (to avoid the VLS UK slant) and shalt not be touching for around 2 decades. Discipline is key for me, and itchy fingers that tinker cause regrets IMO.

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    1. Thanks.

      I hope you did not lose too much by dipping into the Lifestrategy 60. Good luck with the latest 20 yr 'no touch' strategy...I agree, itchy fingers can cause regret and 9/10 the best decision is to do nothing.

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    2. I’m thinking of going all in with Vanguard FTSE Global All-Cap next ISA year. I'm trying to stop tinkering with my investments. I know I’m spending an inordinate amount of time for no discernible gain. I just can’t look beyond the US market looking overpriced at the moment/forecast low returns over the next decade. Thinking about 50% All-Cap and 50% in the 5 ex US regions (UK, Europe, Japan, Pacific & Emerging). That’d be tinkering though wouldn’t it?!

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  2. I don't think there was anything wrong with you banking some profit from your VLS fund. Imagine how you would feel if there hadn't been that 7% rise and instead, the markets had tanked?

    I'm in the process of selling down a few of my individual shares. I've never been good at knowing when to sell so will generally grab profit if it's between 30-50%, although with certain shares, I'm just waiting for them to get back to break even before offloading them!

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    1. weenie,

      You are right and my decision to part sell would have been justified if the markets headed south...which they will eventually so I will need to be a little more patient sitting on the cash proceeds a little longer.

      I have now completed the sale of all my shares so must update the revised portfolio before long. Are you selling off a few of you smaller 'dogs' experiment. I can see from you main shares portfolio that you have so far had mixed fortunes. Hopefully the laggards will start to recover before long...good luck.

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    2. Yes, I will be selling a few of the dogs from the experiment, likely end Jan/beginning of Feb. I'll be selling even if at a loss, as I'll be following the experiment's criteria. Yes, mixed fortunes for the other shares so hopefully a rally at some point!

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  3. As your article states, it is impossible to time the markets! Mr Market does what he wants and sometimes there is no rhyme or reason to it, but at other times there is. Trying to second guess is likely to lead to madness! The story goes that things do not repeat, but they do rhyme (follow a pattern) and that is the best guess one has. So taking some profits when it looks good sounds like a good bet to me.

    As to your questions:

    The state of the markets - Japan looks cheap, Europe more expensive, UK more expensive, but reasonable and as has been the case for sometime, US looks expensive, but it has done for sometime and continues to power ahead (I have been out of it for at least the last 2 years on that basis and what gains have I missed! But we all make our decisions based on what we are presented with).

    Correction - It will come at some point, but I have no clue when; we are into one of the longest bull runs ever, but apart from the US the markets do not look overstretched. But none of us can guess what will actually make the market significantly fall, even BREXIT, as it bounced back so quickly after the vote!

    BREXIT - I was a remainer, but accept the majority vote however slim it was (and I know personally that there were people who voted for it never expecting or really wanting it to happen, but to register a protest vote). How can we be worried about the lack of progress when one party, the EU, has not been prepared to negotiate, but come to the table with a list of demands that it won't budge from, even when the other party has been prepared to show some flexibility. There can be no progress whilst the EU is not prepared to negotiate, except to adopt the attitude to say the negotiations are over and let the EU go and lose any money it could possibly get from us, plus the loss of any trade benefits. I won't quote the facts and figures here, but there are plenty out there, which I'm sure someone will counter; but hey-ho, we all take our positions and have to live with them, just as with investing!

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    1. Gareth,

      Good to hear your views. Markets other than the US may not be so over-valued however, as the US market is so large, it will have a significant impact when the correction arrives - when that will be nobody knows.

      The main sticking point in the Brexit negotiations seems to be money and I suspect we are holding things up by failing to agree to the EU demands. At the same time, I believe it is unrealistic to agree on a figure without an agreement on trade so there needs to be some flexibility from the EU to move things along.

      I am currently thinking no deal may be the outcome but as I said on another blog, I share the view of Nick Train and I am sure things will work out just fine in the long run...they usually do so I am fairly relaxed about things.

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  4. Its the gambler ethos, do you feel more pleased when you've timed the market correctly (won) or not (lost). Gamblers play because they enjoy the process and buzz of winning, but react less to losing. I'm the reverse, so never gamble, and try not to time the market because even if the loading against me in terms of trading fees is less than the rigged odds on the gee-gees, I#m not going to enjoy the game.

    I might trickle large sums in over a month, to avoid single day buyer's regret, but I'd not be out of the market for long periods.

    Having a 4 line entry box makes writing cogent comments here hard.

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    1. vicarage,

      I had thought there may well have been some correction by now but I also appreciate markets can over/under shoot far longer than people would think at times so I remain patient.

      My grandfather was an old fashioned bookie. He said you were onto a winner when there are three windows to take bets and just one to pay-out so I have never really been a gambler.

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