Michael Alexander reports on the results of a test of market efficiency in his book Stock Cycles. He categorized each month in stock return history from January 1802 through December 1999 as offering an above-average return or a below-average return. Then he checked how many of the sequential 50-month time-periods contained more or less than 25 above-average return years. The result was what you would expect from a market that is efficient (that is, a market in which returns follow the pattern of a random walk).
This finding supports one of the core beliefs of both Buy-and-Holders and Valuation-Informed Indexers — the market follows a random walk in the short term. Thus, short-term price changes are unpredictable. Short-term timing can never work.
Stock cycles and long-term timing
The point that is in dispute is whether long-term timing works. The Buy-and-Holders believe that long-term timing does not work but have never been able to show this is so with peer-reviewed research. Once they showed that short-term timing does not work, they jumped to the conclusion that long-term timing does not work either and have resisted calls to respond to the research of Yale Economics Professor Robert Shiller showing that, unlike short-term timing, long-term timing always works.
Alexander wanted to test this for himself. But he couldn’t use the same data set that he used to test whether short-term timing works because performing such a test requires the availability of a larger data set. There are 47 non-overlapping 50-month time-periods in the historical record. Checking how those time-periods turned out is like running 47 tests of 50 coin flips. That’s more than enough tests to produce a conclusion in which you can have a good bit of confidence.
However, there are only four non-overlapping 50-year time-periods in the historical record. If you use the same procedure that was used to check on short-term timing to check on long-term timing, you can only run 4 tests. That’s not enough tests to produce a result in which you can possess much confidence. This is one of the reasons why Buy-and-Hold has remained the dominant model for understanding how stock investing works for so many years since the publication of Shiller’s research. It is harder to explore how the market behaves over longer time periods.
Probability and patterns
Alexander came up with a creative solution to the problem. Imagine that you engaged in a series of coin flips, noted the sequence of heads and tails obtained and then looked for signs of non-randomness. You would be surprised to see the pattern HTHTHTHT (with “H” representing “heads” and “T” representing “tails), THTHTHTH, TTHHTTHH or HHTTHHTT produced as the result of flipping eight coins in sequence. The probability of any of these patterns arising from eight random coin flips is 1 in 64.
Alexander notes that: “A similar pattern in stock returns from sequential periods would also suggest non-randomness.”
He tested this. He explains in the book that: “What we would like to know is whether any of the patterns are sufficiently ‘special’ that its appearance would likely not be the result of chance. In this case we can surmise that there is some non-random phenomenon that produces these alternating patterns of good and bad returns.” He found strong “evidence of non-random behavior on a multi-decade time scale.
Stock cycles aren’t as random as previously believed
The implications are staggering. What Alexander showed is that stock returns do NOT follow a random-walk pattern in the long run (although they do follow such a pattern in the short run). The market is not efficient. 90 percent of today’s investing advice follows from a belief that the market is efficient. Thus, Alexander showed that 90 percent of today’s investing advice is misguided and dangerous.
I believe that it was our decision as a society to ignore the findings of people like Alexander that was the primary cause of the economic crisis. Millions of us have been following bad investing advice for decades now. In the 1980s and early 1990s this did not have much practical effect. Stocks were low-priced in the early 1980s and thus investors were likely to see many years of good returns regardless of what investing strategy they followed.
But by the mid-1990s stocks had become wildly overpriced. From 1996 forward, our belief in Buy-and-Hold strategies has been costing us money. By 2008, our losses had grown so high that we were forced to cut back on spending enough to bring on a deep and long-lasting recession.
Most investors don’t like to look at these theoretical questions. Most investors want their advisors to tell them what to do with their money and to ignore the “why?” questions. The trouble with this approach is that most advisors want to make their readers and clients happy with them and thus feel intense pressures to tell them that bull market gains are real. It is only by asking hard questions as to why the advisor believes what he believes that you can determine whether he is blowing smoke or not. Alexander’s findings suggest that the vast majority of today’s investing experts are blowing smoke (presumably without being aware of it).
Alexander concludes that: “The effect of holding time on stocks in overvalued markets is the opposite of what it is for all markets. Normally, holding stocks for longer amounts of time increases the probability that they will beat other types of investments, such as money markets. This observation led to the commonly held belief that, for long-term investors, any time is a good time to invest. In the case of overvalued markets, holding for longer times, up to 20 years, does not increase your odds of success.”