Valuation-Informed Indexing # 122

By Rob Bennett

I believe that we are going to see a price crash of something in the neighborhood of 65 percent sometime over the next few years. I say this because the current P/E10 value is 23 and there has never yet been a time in U.S. history when a secular bear market came to an end without the P/E10 value first dropping to 7 or 8. It takes that sort of drop to break the bull market psychology that causes and sustains bear markets.

Nobody wants to experience a 65 percent price crash. If people believed me, they would lower their stock allocations. Most people think I am full of it. Most people don’t think it is possible to predict where stock prices are headed. This is not the place to explain why I do think it is possible in some circumstances (please check out earlier columns if you want to know). My aim with this article is to show you how devastating getting hit by a 65 percent price crash can be. While we all know it is a bad thing, the graphics below show that the reality is a good bit worse than the general expectation.

The graphic below compares two 30-year portfolio growth paths. I assumed an investor who today has a portfolio of $300,000 and who will contribute $10,000 to that portfolio in each of the next 30 years. I assumed that the investor will go with a 70 percent stock allocation. In the first scenario (the first set of color bars), the $210,000 in stocks is reduced to $70,000 by a 65 percent price crash before the 30-year return sequence begins. In the second scenario (the second set of color bars), the 30-year sequence begins with $210,000 invested in stocks because the investor pulled his money out of stocks to in anticipation of the crash to protect it.

Here is the graphic comparing the two scenarios:

Suffering a 65 percent hit to your stock portfolio will haunt you for the remainder of your investing lifetime. You will never recover from that hit.

Those are hard words. But I think they are justified by the graphic. I understand that few will take the idea that a 65 percent price drop can be foreseen seriously. Each investor has to make his or her own decision about that sort of thing. But I would feel that I had not done my job if I did not at least make an effort to demonstrate to you how long-lasting the pain will be that you will incur if I am right that a 65 percent price drop is coming and if you do not nothing to prepare for it.

The green bars indicate the best 20 percent of portfolio-value possibilities. The red bars indicate the worst 20 percent of portfolio-value possibilities. The meeting point of the blue and yellow bars indicates the most likely portfolio-value possibility at the specified point in the 30-year return sequence.

At 10 years out, the most likely portfolio value for the investor who avoided the hit is $600,000. For the investor who took the hit it is $250,000. The corresponding numbers at 20 years out are $1,135,000 and $400,000. At 30 years, they are $1,775,000 and 510,000. You won’t come close to recovering from a hit of that magnitude even after the passage of three decades.

The best possible portfolio value at the end of 30 years for the investor who avoided the hit is $2,600,000. For the investor who experienced the hit is is $860,000.

The point being made here is obvious. It is better to avoid a 65 percent price drop than to be hit by one! Surprise! Surprise!

I post the numbers because it is my sense that not many investors are today considering how a 65 percent price drop will affect them. Most investors do not believe that it is possible to predict future returns. So most will not see value in this analysis.

All that I can say in support of the analysis is that we have seen a drop to a P/E10 of 7 or 8 following every earlier secular bull market in U.S. history. The shocking thing would be if we do NOT see such a drop. I cannot explain in full here why big bull markets produce huge price drops but I have discussed the rationale in many earlier columns. The basic point is that the idea that price drops cannot be foreseen is rooted in the research of University of Chicago Economics Professor Eugene Fame and the idea that price drops can be foreseen is rooted in the research of Yale University Economics Professor Robert Shiller. I favor the Shiller model (Valuation-Informed Indexing).

I present these graphics to encourage investors to think over the possibilities that face them. I of course cannot guarantee that we are going to see a 65 percent price drop. I believe, however, that all investors should be aware of the implications of Shiller’s research so that any rejections of the implications of his work will be knowing rejections.

I certainly wish you the best of luck with whatever strategies you elect to follow!

Rob Bennett writes about the many investing insights that follow from Robert Shiller’s finding that valuations affect long-term returns. His bio is here.