When’s the Best Time to Invest in Stocks?
It really is a timeless question, when is the best time to invest in stocks? Is it when stocks have gone up? Is it when stocks have gone down? Is it better to invest today, or wait for next month? And lastly, everyone always wants to buy low, sell high, but how do we know when stocks are low and high?
In this letter, I’ll attempt to answer some of these questions and provide a framework for evaluating the “best time” to invest in stocks.
First off, an explanation on the analysis that follows. For a proxy for “stocks”, we’re using the S&P 500 Total Return Index which contains 500 U.S. listed stocks and reflects the re-investment of dividends. We’re evaluating data since the beginning of 1988, a period of just over 30 years which contains a mixture of bear and bull markets, and analyzing returns and valuations over that timeframe. We are using the price-to-earnings ratio (P/E ratio) as a gauge of valuations and using the trailing twelve months of earnings. Now, onto the analysis!
Return-based Approaches to Timing
One way to think about investing in stocks is whether to invest after the market has gone up a lot, or down a lot. While seemingly in contrast to each other, one could make a strong case either way for both. Let’s take a look at what the data says.
To start with, we need a baseline for evaluation. When looking at the past 8000+ trading since 1988, the percentage of positive return days is 53% and the average daily return is 0.04%. Thus, over long periods of time, investors are better served by being in the market, rather than out of it. This makes intuitive sense as well, if you measure your holding periods in decades and the market tends to go up over time, being invested in stocks tends to provide a better result than holding cash.
Exhibit A: Daily S&P 500 Returns
However, if an investor is looking for an entry point for investing in stocks, what tends to occur if you invest after a down day in the market or after an up day? In essence, do stock tend to rebound if today was a down day, or, do stocks tend to continue the trend, if stocks are up today, there is a greater chance of them being up tomorrow? In evaluating the mean-reversion and momentum effects, we looked at the average returns after down and up days and found there is evidence of mean-reversion occurring in daily return periods. The returns seem on the day following a down day in stocks has a higher average return than our baseline daily return (0.07% vs. 0.04%). And, as one would expect based on that finding, the average daily return following an up day in the market has a lower average return (0.03% vs. 0.04%). Thus, on can say that stocks do appear to mean-revert in daily return periods.
Exhibit B: Daily S&P 500 Return Analysis
With that being said, it is very difficult to take advantage of this mean-reversion. With transaction costs and taxes, this advantage from mean-reversion is largely eliminated. However, what happens if we expand our timeframe from daily to monthly and yearly return periods? Do stocks still exhibit these mean-reversion tendencies over longer-term frames?
For these longer timeframes, we going to introduce the additional concept of standard deviation. Now, instead of just looking at whether the preceding time period was up or down, we’re also going to see if it was outside of one standard deviation. A standard deviation is a common statistic measure of volatility. If one were to plot of the various returns on a bell curve, the standard deviations measure the tails of the distribution. For normally distributed results, 68% of returns are within plus/minus one standard deviation. Thus, for this additional analysis, we will be looking at returns outside of one standard deviation, the 32% of returns which are strongly more negative, or more positive, than average.
Exhibit C: Example of Standard Deviations
So, what does the data tell us for monthly returns? Well, investing after a positive or negative month has no discernible effect of your next return period. Over the past 30 years, the average monthly return has been 0.92%. If you invest after a negative month, your next month return has been on average, 0.92%... And, if you invest after a positive month, your next month return has also been on average, 0.92%. Thus, unlike daily return periods, we don’t see mean-reversion when looking at positive vs. negative returns.
Exhibit D: Monthly S&P 500 Returns
However, what if we look at strongly negative or positive monthly returns, those outside of one standard deviation. Well, the story there is more interesting. If you invest after a strongly negative month, your average next month return is 0.57%. And if you invest after a strongly positive month, your next month average return has been 1.10%. This is quite interesting and a departure from what we saw with daily returns. While daily returns exhibited mean-reversion, monthly returns appear to indicate more of a momentum factor with strongly negative returns leading to further negative returns and strongly positive returns leading to more positive returns.
Exhibit E: Monthly S&P 500 Return Analysis
If monthly returns exhibit momentum, what about annual returns? The short answer is yes.
Exhibit F: Rolling 12-month S&P 500 Returns
We see strong momentum in periods after a negative or positive return as well as in strongly negative or positive periods.
Exhibit G: Rolling 12-month S&P 500 Return Analysis
Valuation-based Approaches to Timing
A second potential way to time new or additional investments in the stock market is to look at how cheap or expensive stocks are. As our measure of “cheapness” we are going to use the price-to-earnings ratio (P/E ratio). The P/E ratio tells us how much in earnings we get for the price we pay. For example, a P/E of 16 tells us that for each $1 of earnings, we are paying $16. A higher P/E means stocks are more “expensive” in that you are paying more for the given level of earnings and a low P/E means stocks are “cheaper”.
For this analysis, we’ll be looking at the market each month and seeing if stocks are unusually cheap or expensive, using our good friend the standard deviation. We’ll compare the current P/E to the unusually high or unusually low P/E ratios over the past 30+ years and then see what returns looked like for stocks over the subsequent 1 year, 5 years, and 10 years.
Exhibit H: S&P Price/Earnings Ratio
What we’ve found in looking at P/E data over the past 30+ years is that there is a strong correlation between lower P/E ratios and higher forward returns with the same applying to high P/E foreshadowing lower forward returns. As you can see in the table below (Exhibit I), over all time periods, buying “low” or when the market P/E ratio is below -1 standard deviation results in a better forward return than average with the opposite holding true for periods where stocks are “expensive” or great than +1 standard deviation.
Exhibit I: S&P Price/Earnings Ratio Analysis
While we see mean-reversion in short time periods, such as day over day returns, a large momentum effect appears to be present in longer time periods such as monthly or yearly returns. In essence, past performance may tend to predicate future returns.
This momentum effect points to a benefit in viewing past performance over the last month or year as an input into your buying decisions.
However, this momentum effect must also be viewed in terms of market valuation.
Using valuation provides an additional tool for making a buying decision in stocks. Unusually low P/E ratios tend to result in higher returns going forward and high P/E ratios result in lower expected returns.
Ironstream uses both momentum and valuation factors in making investment decisions within our Global Equity strategy as well as within our multi-asset allocation targets (cash vs. bonds vs. stocks.)
Lastly, these results must be taken into perspective with average daily, monthly, and annual returns from stocks. Always consider the opportunity cost of waiting for a market pull-back or for a very inexpensive market valuation to invest in stocks.
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The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell, or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Is it not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.