Valuation-Informed Indexing #14
Five Forces That Will Change the Future of Stock Investing

It’s a depressing pattern. Stock prices rise to insanely dangerous levels. That causes a crash. The crash brings on an economic crisis. We dig ourselves out. The fear subsides in time. The cycle begins anew.

It’s always going to be that way. You can watch it. You can learn about it. You can warn people about it. You cannot change it. So the cynics tell me.

I say the cynics are wrong.

There are five forces at work in our economy today that are going to compel us to do something to stop this horrible boom-and-bust cycle:

1) The Middle Class Now Must Invest in Stocks

It’s only in recent decades that stock investing has spread to the broad middle-class. Many middle-class people want nothing to do with stocks. But what choice do they have now that their employers have turned over to them responsibility for financing their retirements? It’s not possible to accumulate the assets needed for a decent middle-class retirement by investing solely in certificates of deposit.

So middle-class workers are in this game to stay. That changes the game. We are today giving exceedingly poor advice to middle-class investors. We are telling them that they don’t need to concern themselves with valuations, that it is okay to ignore price when buying stocks. That’s not going to fly. The losses that follow from adopting such a strategy are too great. As the economic crisis worsens, there is going to be political pressure imposed on The Stock-Selling Industry to provide more realistic guidance.

We require distillers to warn their customers of the dangers of drunk driving. We require the gambling industry to warn its customers of the dangers of betting money they cannot afford to lose. We even require snack manufacturers to reveal on the side of its packages of oatmeal cookies how many calories are being taken in with every delicious bite. Encouraging investors to ignore the price of stocks when buying them has caused the second biggest economic crisis in U.S. history. This cannot stand.

2) P/E10 Is Catching On As a Superior Valuation Metric

Given the popularity of Buy-and-Hold (which posits that allocation changes need not be made in response to valuation shifts), it is remarkable how broad a consensus there is today that valuations affect long-term returns. If just about everyone accepts that stocks offer a better value proposition when they are fairly priced or low-priced, why do so many believe that it is okay to invest heavily in stocks even when prices are insanely high?

A great deal of the confusion stems from the fact that, until recent times, there has been no reliable way to determine when prices are too high. P/E1 remains the most popular valuation metric. But P/E1 produces too many false positives and too many false negatives because it is not well designed to tell us when stocks are truly overpriced. When the economy is going gangbusters, the P/E1 number is artificially low (the “E” number is temporarily too high, given the purposes to which long-term investors are looking at a valuation metric). When the economy is in the doldrums, the P/E1 number is artificially high (the “E” number is temporarily too low, given the purposes to which long-term investors are looking at a valuation metric).

Shiller’s P/E10 metric is becoming more popular. That’s because it works. It tells us what we need to know — how highly priced stocks are relative to the earnings that the underlying companies are able to produce on average. When fair-minded people see how well P/E10 predicts future returns, the scales fall from their eyes and stock investing makes sense for the first time. People who enjoy such lightbulb moments tell their friends. P/E10 will be replacing P/E1 as the dominant valuation metric in coming years and that will help all investors appreciate how critical it is to consider valuations before making any portfolio allocation decisions.

3) Data-Based Analyses Are Objective

The Buy-and-Holders did something wonderful: They made the case for their strategies by pointing to academic research and the historical stock-return data. I believe that that’s what dooms Buy-and-Hold. Once people come to accept that valuations affect long-term returns (Yale Professor Robert Shiller’s research has been showing this since 1981), it becomes clear that all stock analyses must adjust for valuation levels to be accurate. This genie cannot be put back in the bottle. People may give up on Buy-and-Hold but they are not going to give up on the idea of rooting their investment strategies in something objective. What will change is the way the methodologies used in the studies are set up.

The Boom-and-Bust cycle is fueled by investor emotion. Data-based analyses are the enemy of emotional approaches. In the future we will be revisiting all of the conventional wisdom of the Buy-and-Hold Era to identify the realities as they apply in the real world (where valuations matter). Emotional Boom-and-Bust cycles are a logical impossibility in a world in which most analyses are data-based.

People don’t see this yet because in the grand scheme of things the idea of rooting investing analyses in data is so new an idea. In days to come, people will look back at the idea that valuations do not need to be considered in investing analyses as a fad. We will soon be entering a post-Buy-and-Hold Era in which the historical data will be used not to encourage investors to stay at the same stock allocations at all times but to encourage them to be sure to regularly revisit their stock allocations in light of changing valuation levels.

4) The Internet Changes the Balance of Power

Investors benefit from valuation-informed strategies because these are the strategies that work. But The Stock-Selling Industry benefits from Buy-and-Hold strategies because these are the strategies that appeal to the Get Rich Quick impulse within all of us; these are the strategies that sell. For now, the industry has the dominant influence in determining what analyses we hear about.

That won’t remain true for long. The internet has provided middle-class investors a means to share with each other information re what works. Once enough middle-class investors learn the realities, the industry will have no choice but to go along.

5) The Bull Market of the 1990s Went Too Far

The Boom-and-Bust Cycle has caused great damage to investors for as far back as the day the first stock market opened for business. But never have we seen anything as dangerous as the bull market of the late 1990s. We have seen a stock crash and an economic crisis on every occasion on which the P/E10 level has risen above 25. The one time when we permitted it to go to 33, we experienced The Great Depression. In the late 1990s, we left a P/E10 level of 33 in the dust. We went to 44. At the top of the out-of-control bull, we saw a market overvalued by $12 trillion, an amount that we have not paid back even after a Lost Decade for stock investors.

People forget little storms. People do not forget hurricanes. We are now living through the aftermath of a hurricane-of-destruction bull market. People are not going to forget this one for a long time. The stronger an action, the greater the reaction it inspires. By the time we recover from the bull market of the late 1990s, people are not going to want to hear the phrase “bull market” for generations. We are on the threshold of a time when interest in driving a stake through the Boom-and-Bust Cycle will be stronger than it has ever been before.