Valuation-Informed Indexing #108

by Rob Bennett

Yale Economics Professor Robert Shiller changed the history of investing analysis with his 1981 finding that valuations affect long-term returns. That means that price changes are caused not by day-to-day economic developments but by investor emotions, and that long-term returns are to a large extent predictable. Shiller is the grandfather of Valuation-Informed Indexing, the model for understanding how stock investing works that I believe will in time come to replace the discredited Buy-and-Hold Model.

That said, Shiller’s advice on the practicalities of stock investing often leaves something to be desired. He offers better advice than most Buy-and-Holders. Unfortunately, that’s not saying much. I have been following Shiller’s comments on the how-to questions of stock investing for several years now and, while there are almost always valuable insights contained in them, I cannot recommend that investors follow his advice without exercising a good deal of caution in doing so.

In the months following the 2008 crash, Shiller offered advice that was so negative on stocks that I wouldn’t argue too much with someone who referred to it as “extreme.” At that time, he was saying that it would not be safe to get back into stocks until the P/E10 level dropped below 10. That’s more than a 50 percent drop from where we stand today.

There’s a case that can be made for staying out of stocks until the P/E10 level goes below 10. In each of the three full bull/bear cycles we have experienced, we ended up at a P/E10 of 7 or 8 before the bear cycle exhausted itself and we saw valuation levels begin heading upward again. If you wanted to get back into stocks at just the right moment, you might wait until the P/E10 level went to 8 and then go to a high stock allocation to enjoy the rewards that come to those invested in stocks when valuation levels are rising.

That’s not a smart approach, however.

The fact that we have always in the past hit a P/E10 level of 8 is a strong indicator that we will hit a P/E10 level of 8 this time. There’s better than a 50 percent chance that the advice given by Shiller in the wake of the price crash will pay off. Still, it is not good advice. There is also a significant chance that we will not hit 8. We might see a turn at 10 or 12 or possibly even 14. Why take a chance on missing the turn? What sense is there in that?

If it were a terrible thing to be invested in stocks at 14, I could see waiting for a lower P/E10 value before committing to stocks. But stocks offer a powerful long-term value proposition when priced at a P/E10 of 14. The most likely annualized 10-year return on stocks purchased at a P/E10 of 14 is over 6 percent real!

So I do not at all go along with Shiller’s idea that it makes sense to wait for a very low P/E10 level before buying stocks.

He is giving different advice today, at any rate. Shiller said in a recent interview that stocks are priced today to provide a long-term return of 4 percent real. That’s a higher number than the one you get from my Stock-Return Predictor (2.2 percent real), but it’s not crazy high. Modest changes in assumptions might generate a return expectation as high as 4 percent real. I don’t fault Shiller too much for the return expectation.

What bothered me about Shiller’s recent comments was the complacent way in which he presented the information. He offered a comment about the 4 percent return expectation: “Not bad.” That comment offers encouragement to investors either holding onto their high stock allocations or thinking of shifting to high stock allocations. I don’t see such encouragement as being justified by the realities, even if the 4 percent return expectation is not out of line.

There’s more than one way to get to a 10-year annualized return of 4 percent real. You could have returns of 4 percent, 4 percent, 4 percent and 4 percent for 10 years running. That would indeed be a “not bad” result.

Another way to get there would be to have a second crash sometime in the next year or two, following by returns significantly better than 4 percent real for the remainder of the 10-year time-period. Going by history, that’s the far more likely scenario. Investors are intensely emotional today. That’s a bad sign. Bear markets don’t end when investors are this emotional. That’s why we always see drops to lower P/E10 levels before bears exhaust themselves.

If an investor knows that another crash is likely and elects to go with a high stock allocation anyway because he believes that the 10-year return will be acceptable, that’s a perfectly valid choice. But the vast majority of investors who hear Shiller’s words are not going to be forming that expectation by hearing his words. Most investors who either stick with high stock allocations or move to high stock allocations today are going to sell if we see another crash. We should not be doing anything to encourage people who don’t appreciate what may be on the horizon to take on risks they cannot handle.

Shiller understands things about stock investing that the Buy-and-Holders do not understand. But he is influenced by the same forces that influence the Buy-and-Holders. Do you want to know what he shaded his investing advice in an anti-stock direction in the months following the crash and is shading it in a pro-stock direction now that many investors have come to view the crash as ancient history? That’s what sells. That’s what the producers of the television and radio shows want to hear from their expert guests. Most viewers of such programs want to hear today that investing heavily in stocks today will yield “not bad” results.

The experts need to resist these pressures. That’s the job. An expert is someone who knows more than the man or woman on the street. We need investing experts who tell us the straight story even when doing so means not getting invited back to the most popular television and radio programs on investing.

Rob Bennett has written about the shame (and pride!) of expecting an inheritance. His bio is here.