The Challenge of Predicting the Short Term
Large swings in the market this year have led to an increasing focus on near-term market calls. Correctly call the next meaningful move in the market and your fortune awaits! The S&P 500 reached an all-time high in February before falling over one-third in five short weeks on the back of fears about COVID-19. In response to support from the Federal Reserve and Congress, shares then rallied significantly, up over 40% from the lows and now just under 10% below the highs reached in February. The ecosystem that has been built up around the market has always encouraged activity, with everything from tailored ETFs to play specific themes to countdown clocks and recommended “halftime trades” on CNBC. This persists because many players depend on activity in order to make money. The appeal is obvious—the chance to get rich quick. After all, anybody who correctly called the gyrations in the first six months of 2020 would have pocketed years’ worth of gains.
This recent volatility has led to an increase in the question, “what do you think of the market right now?” from people I meet when they find out what I do for a living. Usually this query is accompanied by the expectation I will have some insight as to where it is going next. Humility isn’t usually rewarded in these scenarios—people want to hear that you have the answers. You are a professional, after all. Shouldn’t you know? In support of this expectation, I’ll cite the parade of investment professionals on TV, who more often than not possess an uncomfortable level of certainty in answering this question. Fortunately, none other than Warren Buffett has provided some cover for us professionals who believe correctly calling the next market move is next to impossible. When asked in interviews what he thinks the market is likely to do next, Buffett gives the same answer he has repeated for years, “I can’t predict where stocks are going to go in the next day, the next week or month or year.” He has said this so frequently that you can almost see him hit the “playback” button in his mind when the question is asked.
This doesn’t mean we don’t have (hopefully well-formulated) opinions on where things generally might be headed, or that we don’t adjust our behavior in response to those beliefs. As fundamental investors, we naturally tend to find relatively fewer attractive opportunities in what we view as an expensive market and more opportunities in markets that generally appear more attractively priced. This results in a slightly more offensive or defensive posture depending on our collective view of the environment, but it doesn’t cause dramatic shifts in equity exposure, in adherence to a longer-term, already considered plan.
To be more blunt, despite the potential riches that await market timers who deftly sashay in and out of the market, timing the market is incredibly hard and research on the subject has shown it does not work. Investing legend Peter Lynch once said, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Nobody has the statistics to back this up but I’m almost certain he’s correct. Furthermore, even if one correctly sells before a market decline, they would also need to accurately predict when to get back into the market. Being right once on a short-term move is hard, getting it right twice is nearly impossible.
How about individual stocks instead of the overall market then? Maybe those offer the opportunity to make money via market timing. Individual stocks provide an even more stark illustration that strange things can happen in the near term, increasing the challenge of market timing and pointing investors to the sensible application of longer-term horizons. Consider the recent example of Hertz, the rental car company that filed bankruptcy in May. Despite being almost certainly worthless, shares subsequently rocketed above their initial post-bankruptcy price, riding what appears to have been a wave of speculative frenzy.
The first trading day after bankruptcy, Hertz shares closed at a price of $0.56. Over the next two weeks, “investors” bid up Hertz’s stock, resulting in a price increase of nearly 10x to over $5.50 a share. Defying logic, this gave Hertz a market capitalization of over $750 million, for a company that had already declared bankruptcy! Corporate bonds, which have higher priority claim on the company’s assets than stockholders, and would be fully paid off before stockholders would receive anything, were trading at around 40 cents on the dollar. This implied a further ~$1.8 billion would be needed to make bondholders whole before stockholders would receive a dime—an unlikely prospect at best.
Given the seemingly irrational fervor with which the market was bidding up its shares, Hertz looked to take advantage by issuing $500 million in new stock, the proceeds of which would be used to shrink the $1.8 billion owed to bondholders. Highlighting the absurdity, the risk section of the prospectus for the offering detailed “common stock holders would not receive a recovery through any (bankruptcy) plan unless the holders of more senior claims and interests are paid in full, which would require a significant and rapid and currently unanticipated improvement in business conditions… there is significant risk that the holders of our common stock, including purchasers in this offering, will receive no recovery under the Chapter 11 Cases and that our common stock will be worthless.” Sounds great! Where do I sign up?
Ultimately the SEC put a halt to the share sale. But the question is why did shares shoot higher when a reasonable analysis of the underlying value of Hertz stock would conclude it is worthless? There is some speculation that with no sporting events to wager on people have instead turned to the stock market as a source of entertainment. There may be some truth to this, but similar crazy price moves have occurred in the market forever. As legendary investor Benjamin Graham wrote decades ago, “The speculative public is incorrigible. It will buy anything at any price, if there seems to be some ‘action’ in progress.”
Getting back to market timing in general, I’m not saying timing the market can’t be done, I’m just saying it is incredibly difficult and highly likely to be a loser’s game. Buffett is more skeptical, “I don’t think anybody knows what the market’s going to do (in the short term)… but in the long-term is very easy to predict in a general way.”
Where does that leave us? I’m likely preaching to the choir but the message is important enough that it bears reiterating. Have a long-term plan and asset allocation that reflects your goals. Changes in life circumstances are a good reason to potentially adjust target allocations, concerns regarding what the market might do next usually are not. Over the long-term stocks have shown to be an attractive vehicle to grow wealth. Taking an ownership stake in a basket of growing companies with attractive cash generation profiles and reasonable valuations continues to be a sensible strategy to increase the odds of long-term success.
James M. Skubik, CFA