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Is it time to take profits – or stay put? A contrarian suggestion

One quick look at today's frothy stock prices is enough to suggest it's time to run for cover. So why are investors doing exactly the opposite and rushing into an eight-year-old bull market with mounting enthusiasm?

You can blame their high spirits on irrational exuberance or on a severe case of Trump-induced euphoria. But a more profound reason is that it's tough to know exactly when to get out of stocks – especially at a time like now when the miserable yields on bonds offer no obvious alternative and the global economy is showing signs of strength.

That leaves investors with two contrasting but equally ugly choices. The first is to pile into a geriatric boom that has already propelled Wall Street to giddy valuations. The second is to buck expert opinion and try to time the market.

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There's a lot more to be said for that second option than is usually recognized. But before getting to the contrarian case for market timing, let's first assess the compelling evidence for the other side, beginning with a classic study by market historians Elroy Dimson of Cambridge University and Paul Marsh and Mike Staunton of the London Business School.

The three researchers used historical data to test a strategy that sold stocks and sheltered in cash whenever stock prices hit extremely high levels compared to their dividends. The strategy re-entered the market only when the price-to-dividend ratio subsided to cheaper levels.

It sounds like a clever system. Unfortunately for would-be market timers, the researchers found that in each of the 20 countries they examined, investors would have been better off by simply staying in stocks.

Aswath Damodaran, a professor of finance at New York University, recently reached a similar conclusion using the popular CAPE ratio.

CAPE, which stands for cyclically adjusted price-to-earnings ratio, measures current market values against real corporate earnings over the past 10 years. It offers a handy gauge of how today's stock prices compare to the market's sustainable level of underlying earnings over a complete business cycle.

CAPE rose to glory by flashing red during the late 1990s, when the dot-com insanity was roaring ahead. Unlike many indicators, CAPE offered clear warning of the crash that was to come.

These days, CAPE is signalling trouble once again. At 29, it's hovering at its highest level since the dot-com crisis and is far above its historical median of 16.

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But can you actually make money by scrambling out of the market at times like now, when it's clearly expensive, and waiting to get back in when prices fall back to more attractive levels? As reasonable as that idea sounds, it's difficult to choose a cutoff that actually works.

For instance, an investor who put $100 into the U.S. stock market in 1927 and dodged out of the market whenever CAPE was 50 per cent or more above its historical median at the time would have wound up with nearly $138,000 in 2016. They would be far behind a simple buy-and-hold investor, who would have seen their $100 grow to more than $320,000.

Prof. Damodaran has played with various CAPE-related market-timing strategies and found nearly all of them would have cost investors money over the past 90 years compared to a simple buy-and-hold strategy. Even apparently astute timing strategies tend to get you out of the market too early or too late. "The bottom line is that it is tough to get a payoff from market timing, even when the pricing metric that you are using comes with impeccable credentials," he writes.

Fair enough. But here's where the contrarian case for market timing comes in.

Most market-timing tests assume that if you're not in stocks, you will be in cash. A better strategy may be to stay in stocks, but in areas that can buffer Wall Street's most manic tendencies.

Some obvious candidates right now are emerging market stocks, which appear much cheaper than their North American counterparts in terms of CAPE. Global stock markets tend to be highly correlated so if Wall Street does tumble, these foreign markets will be hit as well. However, the potential damage appears considerably less given the much lower valuations of emerging market stocks.

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Another approach is to focus on North American stocks with defensive characteristics. A recent paper by Niels Gormsen of Copenhagen Business School and Robin Greenwood of Harvard Business School looked at "rainy day stocks" that have the potential to weather bad times.

The researchers found that low volatility stocks trading at low price-to-book values tend to do relatively well during rough patches. These stocks – typical of the type held by many value-oriented funds – still lose money but suffer only about a third of the losses of the overall market.

Better yet, these rainy day stocks also perform fairly well during good times. In today's market, that sounds like a fine deal indeed.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More


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