Valuation-Informed Indexing #133
by Rob Bennett
You see it all the time.
Congress and the President are at loggerheads re the debt ceiling and stock prices fall. An article appears explaining that investors place less value on corporate shares because it appears that the U.S. credit rating is about to take a beating.
Or Congress and the President agree to a deal and prices rise. So an article appears explaining that our economic future looks a bit brighter than it did before and that stocks thus merit the higher valuations.
It certainly appears to be more or less so. Good things happen and prices go up. Bad things happen and prices go down. Stock prices reflect the economic realities.
Yale Economics Professor Robert Shiller proved that this is not so with his 1981 research showing that valuations affect long-term returns. Not many have yet explored the implications of Shiller’s revolutionary research. So you don’t often hear the conventional wisdom on this question challenged. But Shiller’s findings discredit the conventional understanding of how market prices correlate with the economic realities.
If the conventional understanding were accurate, changes in stock prices would play out as a random walk. They don’t, not in the long term. So the conventional understanding is wrong.
There clearly is some connection between stock prices and economic realities. When we see devastating events like the 911 terrorist attacks, prices fall hard. The bad news influences the beliefs of investors and those beliefs cause investors to reevaluate their assessments of the value present in their shares. There is a connection but there is not nearly as strong a connection as is commonly believed.
Following 911, prices fell hard and then a few days later recovered. Did the economic realities change in a significant way? No. Emotions changed. Investors got scared and prices changed to reflect their fears. Then investors got over their fears and prices changed again to reflect the new spirit. It is investor emotions that cause price changes and economic realities only sometimes affect investor emotions in logical ways. On other occasions, the effect can be perverse.
So it is a big mistake to draw conclusions about the state of the economy by looking at day-to-day market prices.
There’s one sense, however, in which I think it is a good idea for investors to use market prices to help form their assessments of how the economy is going to perform on a going-forward basis.
We have 140 years of price data available to us. We have had huge bull markets. We have had huge bear markets. We have had years when stock prices rose 50 percent and we have had years when stock prices fell 50 percent. I believe that all that short-term stuff should be ignored. There’s one correlation that has always remained solid over the course of those 140 years -- the U.S. economy has always remained sufficiently productive to support an annual average increase in stock prices of 6.5 percent real.
That’s what matters. We should tune our all the short-term numbers and focus in on that one highly compelling eternal reality.
Stock values increase by 6.5 percent (after inflation) every year.
Please notice that I said “values” increase by this much every year, not that prices do.
Stock values increase by 6.5 percent during bull markets, when the price increases are often 20 percent or 30 percent or 40 percent.
And stock values increases by 6.5 percent during bear markets, when the price drops are often 20 percent or 30 percent or 40 percent.
Stock value increases are highly predictable. We can know in advance how stocks are going to do. Their value is going to increase by about 6.5 percent each year. That’s it. it’s that simple.
Who said stocks are risky? There’s no risk if you know in advance what is going to happen.
Why doesn’t everyone look at it this way? We get caught up in the short-term craziness. We look at prices instead of values (which can be properly identified by making an adjustment to the nominal price to reflect the P/E10 value that applies at the moment). We take the risk out of stock investing when we force ourselves to ignore price movements, which are chaotic because they are driven by emotion, and focus in instead on value movements, which have been highly stable for 140 years now.
Put $10,000 in an index fund and in 12 months time you will have an asset worth about $10,650. In 24 months, you will have an asset worth about $11,300. In 36 months, you will have an asset worth about $11,950. Like that.
Stocks provide safe and steady returns. They always have. They always will.
The only reason we don’t see it that way is that we get caught up in the short-term craziness. We shouldn’t. We don’t invest for the short-term. We invest for the long-term. So when we want to know the value of our portfolios, we should check out the long-term lasting values. not the short-term temporary values.
Adjusted prices are the real prices.
When hard economic times come, the companies that make up the market are not losing money. They are making the adjustments they need to make to compete more effectively