Dear Investor,

Happy new year. Wishing you and your family great health and happiness. Below is the chart comparing our performance to the benchmark.

In this update, we will examine whether timing the market can lead to better returns. The most common query we are posed by our prospective clients is whether it is a good time to invest given maybe the market is at an all time high. In fact, we have experienced that this is a question we are asked more often than other more relevant questions that prospective clients should ask of active fund managers like us: how our strategy is differentiated, how do we manage risk in our strategy, are we flexible to change our strategy in different market scenarios given no strategy works in all market scenarios, etc.

We will be looking at historical data of the past 50 years of S&P 500 to check whether market timing can lead to better returns. We have chosen a US Index only because we don’t have 50 years trading history for Indian indices like Nifty 50 or BSE Sensex. Also, S&P 500 index is a more broad-based index and is thus a much better representation of overall market behaviour.

We compare the returns generated when invested in S&P 500 on any day historically with 2 different scenarios:

Returns when someone invests in S&P 500 only on the days when it hits an all time high (ATH). Logically this sounds like a very risky strategy as investment is being done when markets (as represented by the index) are at an all time high. This will help answer whether an investor should wait to invest for markets to correct if it is hitting an all time high. A most common question posed to us as we noted above.
Returns when someone invests in S&P 500 on the days when it has corrected 20% from its previous all time high level. Logically this sounds like a safe strategy as investment is being done when the market has entered a bear phase. A correction of 20% from previous high is considered as the market entering a bear phase. So, investing at bear market levels should logically offer better than average risk reward pay off.

Below is the chart of S&P 500 index over last 50 years:

First, we look at the statistics of 1 year, 3 years and 5 years returns (CAGR in case of greater than 1 year holding period) generated if we invested on any day in S&P 500 over the last 50 years. There were 12,607 trading days of S&P 500 over the last 50 years period ending on 23rd Dec 2022. We calculated the 1 year, 3 years and 5 years returns generated if we invested on each of the 12,607 days. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years returns in a tabular form.

*when holding period is > 1 year, return means CAGR generated wherever mentioned in table

Now we will look at the statistics of returns generated when an investor invests only on days when the S&P 500 hits an all-time high. There were 864 such days in the last 50 years of trading history of S&P 500 thus the set of samples is obviously smaller compared to the above analysis. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years return in a tabular form for this analysis.

There is hardly any difference in the statistics in the above table compared to the statistics in the table when investing was done on each trading day in S&P. The median 1 year, 3 year and 5 year returns are almost the same. Moreover, the probabilities of loss in capital invested (-ve returns) and of generating 10% or higher annual returns is almost similar to if one invested on any given day in S&P 500. The only difference is that the min, max returns as well as the volatility of returns (as measured by standard deviation) in this case are lower than if we invested on any given day in S&P 500. This we guess is a positive trait as it indicates lower volatility.

The results seem to be contradicting our intuition that returns should be significantly lower if one invests in equities when the market (as represented by a benchmark index) is at an all time high. There are couple of reasons for this:

A.) Bull markets last much longer, typically 5-6 years, than bear markets, typically 1.5-2 years. If we just take a look at the 50 years chart of S&P 500, we can see bull cycles:

From 1991-2000 till it ended with the dotcom bust
From 2003-2007 till it ended with the Lehman crisis
From 2009-2021 end with a very minor (time wise) blip related to the coronavirus pandemic scare lasting only ~6 months or so over March to October 2020

So, if one stays away from the market when it hits an all ATM, specially in early days of a bull cycle, he/she will find it most difficult to get in at a later stage due to anchoring bias and may miss the entire cycle. An important question to consider is how does one know when the market starts to hit an all-time high that it is not the start of a multiyear bull cycle?

B.) Indices or particular equities only hit a high typically when macros are positive, earnings growth prospect is strong, etc. Most often this confluence of positive factors remain in place for a while till some macro turns negative or in case of a particular stock if there is a major misstep by the company. So, it makes sense that when the index hits an all time high, there is a good probability it will keep on hitting further highs for a while. A very popular and proven technical style of investing - ‘momentum’ investing is based on investing in stocks when they hit an all-time high. There are active fund managers who have used this strategy to deliver attractive returns.

We are fundamental bottoms up investor and do not use any technical style but even for us, our greatest winners like TD Power, FIEM Industries, etc have kept on making new highs over time and contributed the most to our returns. We first started investing in FIEM at INR ~400 level and in TD Power at around INR ~25 level for our oldest clients. Subsequently we kept on averaging up both of these 2 stocks in older portfolios as well as bought these at different higher levels in new clients. In fact, we are still investing in both these companies at current levels or at slight discount for our new clients as well as averaging up in older portfolios. A very important point to remember is how a stock or overall market has reached a particular level is irrelevant. If it makes sense to invest from a bottom up perspective due to attractive valuation and strong earnings prospects, then one should obviously invest rather than hoping and waiting for a better entry point.

The last analysis we will do is evaluate whether investing only on days when S&P 500 corrected 20% or higher from previous high is an attractive investing scenario. Below is the distribution of 1 year returns in a chart form as well as different statistics like mean, probabilities, etc for the set of 1 year, 3 years and 5 years returns in a tabular form for this analysis.

Comparing the results from this scenario with the above 2 scenarios, one thing which is clearly different is that the probability of -ve returns or basically dip in capital invested reduces substantially. This makes sense because if one invests after the index is already down 20%, then chances of losing money from that point is significantly lower. Other parameters like median return and probability of generating 10% or higher annual return are almost similar to the above 2 scenarios. So, one can conclude a 20% or higher correction offers better than average risk reward payoff as risk of capital loss is lower.

Overall, our conclusion from the above historical analysis is that it does not make sense to wait for a correction to invest when markets are at an all time high or in general post a period of good returns. However, on the other side, market correction by 20% or higher from a previous high offers a better than average risk reward payoff.

Please let us know if you have any questions / concerns.

Thanks

Prescient Capital

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Investor Memo Dec 2022

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