Mean Reversion and Market Timing

For some time I have been a little concerned about the high valuation of equities, particularly in the US. It is just over 12 months since I decided to sell 25% of my Lifestrategy 60 fund. 

In addition I have continued with the selling down of individual shares as well as top-slicing a few of my equity income trusts.  Added to this has been the fall in the value of sterling post the Brexit referendum result in June 2016. This factor alone boosted the value of my Lifestrategy holding by ~12% over the year (and other funds) as they are denominated in US dollars.

Unfortunately, the timing of these sales was probably a little premature - the equity markets have continued to rise and there has not yet been much sign of any sustained recovery in sterling, maybe we will need to await the outcome of the prolonged Brexit negotiations. 

The value of my Lifestrategy 60 fund has increased by a further 7% since last October. In the meantime the sale proceeds remain in cash waiting for a suitable opportunity to reinvest.

VLS 60 past 12 months (click to enlarge)

Reversion to Mean

This is the well-known principle which suggests the price of any particular asset class, however volatile over the shorter periods, will eventually return to its long term average. Here's my post from2014 which describes it in more detail.

The US equity markets have been trading well above their long term average for some time and sterling has been well below its average compared to the US dollar since June 2016. It would therefore be logical to conclude that there will be a correction - the US markets will fall and sterling will rise. The only part of the equation creating a problem is when this will take place. Markets can move against the tide for lengthy periods.

Market Timing

Markets rise and fall so it should be easy to buy low and sell high. When the markets fall back, repeat the process. It sound like a reasonable strategy but in practice, it is very difficult to achieve...in fact, many new to investing do the exact opposite. Therefore the traditional wisdom is to avoid trying to time the purchase/sale of investments but merely buy and hold long term. This is the strategy I try to stick to but I am human and my weakness is a temptation to tinker around the edges.

However, surely if the concept of mean reversion is valid, it should be possible to take advantage of market timing over the same period that an asset class is reverting to its long term average. This is the conclusion of Peter Spiller in his most recent quarterly report (pdf) to shareholders (always a good read).

Spiller has managed the Capital Gearing Trust for 35 years and has a very good track record. I actually added it to my portfolio earlier this year - not for income but as an option to preserve some of the gains made from equity holdings in recent years.

He articulates the case for market timing in a way that intuitively makes sense to my way of thinking and concludes that when the outlook is poor, it is better to hold a reduced weighting to the riskiest assets and wait for better opportunities down the line.

Rebalancing

Of course, the most common way to counter the additional risk to my portfolio from the rising equity element is to rebalance  - sell off the equity gain and redistribute to bonds/cash. This has the effect of ensuring the portfolio remains at a level with which I am comfortable. Indeed one of the great features of the Lifestrategy range is that this aspect is automatically built-in to the fund selected.

Indeed, some of the proceeds from my equity income fund sales and share sales has been reinvested into more cautious funds - the likes of AJ Bell Passive (Moderately Cautious) and CGT.

So the obvious question would be...why did I feel the need to sell a proportion of my VLS fund last October? I think the main driver was the dramatic 20% fall in sterling which artificially boosted the value of my VLS fund. Combined with the fact it was (and still is) the largest single fund by value in my portfolio made me a little unsettled with the prospect of sterling reverting back at some point. Also, the fund holds a large proportion of the US equity market which was trading and continues to trade at all-time highs.

Seeing how things have unfolded over the year, it was probably the wrong thing to do but maybe if I remain patient a little longer it will become a good call.

So maybe my intuitive move to reduce some exposure to equities as the markets have risen over many years combined with a further boost from the fall in sterling can become part of a strategy which offers some flexibility. I am still in the process of thinking this through a little more to try and clarify my own thoughts but feel sure that it should be possible to come up with a formula to compliment a rigid rebalance between equities/bonds/cash - a sort of Rebalance++ option.

As I posted earlier in the year, I'm not suggesting current levels represent the top of the market bull run as I know it is impossible for anyone to predict the top (...or bottom). However, at this point in the cycle, my preference is to hang on to the some of the capital gains accumulated since 2009 rather than stay fully invested in the hope of squeezing out even further gains.

It seems I may have a longer wait than first anticipated before the opportunities present themselves but, unlike the fund managers, I have no responsibilities to other people and I am happy to sit on the cash for as long as needed.

Feel free to comment on the current state of the markets and whether you are concerned about a correction. Are you worried about the lack of progress on Brexit and the real possibility of a no deal?