Valuation-Informed Indexing #209

by Rob Bennett

The core idea of the Valuation-Informed Indexing strategy is that, since valuations affect long-term returns, investors must be wiling to adjust their stock allocations in response to big valuation shifts to have any hope of keeping their risk profiles roughly constant. People hear that the P/E10 value determines what their stock allocation should be and they ask what stock allocation percentage is associated with each P/E10 value.

It doesn’t work like that.

In a general sense, it does. It certainly is fair to say that, as valuation levels increase, the investor stock-allocation percentage should fall. But saying that valuations must be taken into consideration when setting your stock allocation is not the same thing as saying that ONLY valuations should be taken into consideration when setting your stock allocation. You have to leave room for other factors.

No one ever asks Jack Bogle what stock-allocation percentage should apply for all investors, do they? The only difference between Buy-and-Hold and Valuation-Informed Indexing is that Valuation-Informed Indexers change their stock allocations in response to big valuation shifts. It is still not possible to determine the proper stock allocation for an investor without taking into consideration the investor’s life goals and financial circumstances.

Investors saving for short-term goals like the purchase of a house need to go with different stock allocations than investors saving for long-term goals like the financing of a retirement. Investors who are close to retirement age should generally be going with different stock allocations than investors just beginning to accumulate savings. Investors with low risk tolerances should be going with different stock allocations than investors with high risk tolerances.

All of that is familiar to investors familiar with the Buy-and-Hold strategy. The difference with Valuation-Informed Indexing is that the investor who determines that under the Buy-and-Hold strategy he would be going with a 60 percent stock allocation at all times will instead be going with a stock allocation of 30 percent when the P/E10 value is high (above 22), a 60 percent stock allocation when the P/E10 value is moderate (between 16 and 22) and a stock allocation of 90 percent when the P/E10 value is low (15 or lower). The peer-reviewed academic research of the past 33 years shows that stocks are more risky when valuations are high. So investors MUST be willing to change their stock allocations in response to big valuation shifts to have a realistic hope of achieving long-term investing success.

However, it’s not only the P/E10 value that matters for those seeking to incorporate the valuations factor into their investing strategy. You also have to consider the return you will obtain on the non-stock asset class you choose. TIPS and IBonds were paying 4 percent real in 2000, when stocks were priced to offer an annualized return of something in the neighborhood of a negative 1 percent real. That one was a no-brainer. There have been times in recent years when the return on the super-safe asset classes dropped to close to zero. In that sort of environment, there is more of a price to be paid for being out of stocks. So you might want to tilt things a bit more in the direction of stocks in such circumstances.

It’s also important to keep in mind that P/E10 values do not pop up randomly. There is a pattern that has applied for the entire 140 years of stock market history. Prices start out low. Then they rise steadily for perhaps 20 years. Then they fall sharply and remain low for perhaps 10 years. Prices behave in that matter because the natural impulse of investors is to push prices up. They continue doing this until their common-sense understanding that there are limits to how high prices can go kicks in to cause prices to crash. Then the economic devastation that follows from the huge loss in consumer buying power causes investors to hate stocks for a good bit of time.

A P/E10 value of 15 represents fair-value pricing for stocks. But a P/E10 value of 15 signals something very different when prices are on their way up to a P/E10 value of 25 or more than it does when prices are on their way down to a P/E10 value of 8 or less.

Shiller recently pointed out in an interview that, while a P/E10 value of 25 is high, it is possible that the P/E10 value could rise to 30 or even higher (we went to 44 in 2000). That’s so. It’s important to remember, though, that stock are an insanely risky asset class when the P/E10 value is 25 and all that happens when the P/E10 rises even higher is that an insanely risky choice becomes even more insanely risky. Personally, I don’t get enthused over investing in either insanely risky asset classes or in super insanely risky asset classes. I am inclined to take a pass both when the P/E10 value is 25 and when it is 30.

That said, we went to 25 back in the mid-1990s and didn’t see a crash until 2008. Investors who invested heavily in stocks in those years were taking a big chance. But a lot of them don’t regret the choice now that they know how things turned out.

Those investing heavily in stocks selling at a P/E10 value of 25 in the early years of a secular bear market are taking a bigger chance. At this end of the cycle, stocks are headed toward a P/E10 value of 8 (we have gone to a P/E10 of 8 in every secular bear market in U.S. history) in the not-too-distant future. Shiller is right that we might temporarily go to 30 or even higher. But how long are we likely to stay at such high P/E10 levels? When we see 30 on the way up, the odds that we will be at high P/E10 values for some time yet is greater than it is when we see 30 on the way down.

Rob Bennett has recorded a podcast titled You Can Get Rich Slow While Also Getting Rich Quick. His bio is here.