Valuation-Informed Indexing #212
by Rob Bennett
Trillions of dollars of investor wealth evaporated in the space of a few months in late 2008. Buy-and-Holders reassured themselves by telling each other than no one could have anticipated such an event. Every now and again there’s one of those “Black Swan” events. You just need to try to forget about it and get back up on the horse.
Unexpected events present an opportunity for learning. If events do not transpire in the real world as your model tells you they should, you need to take another look at that model.
The reality is that a small but not insignificant number of investing analysts were expecting to see the sort of crash we saw in 2008 for some time before it came along. I remember a conversation that I had at a discussion board with a fellow who expressed certainty that the P/E10 value would never drop below 20 again. When we hit 13 in early 2009, he didn’t abandon the Buy-and-Hold Model that informed his thinking on these issues. He blamed that darn Black Swan. How could anyone ever anticipate a Black Swan?
There’s a funny dynamic that governs our rationalizations for not taking P/E10 levels into consideration when deciding on our stock allocations. When the P/E10 level rises to high but not insanely high levels, we say that moderately high P/E10 aren’t really all that dangerous. When the P/E10 level rises to insanely high levels, we say that the results that logically follow from insanely high P/E10 levels are so absurdly bad that it is impossible that the P/E10 metric will continue to worksas well as the entire 140-year history of the market shows that it performs. If P/E10 worked as well as it appears to work, we never would have permitted things to get so out of hand, say the people who counseled ignoring merely high P/E10 levels on grounds that anything less than insanely high P/E10 levels were not worth worrying about.
Here’s what Shiller says in Irrational Exuberance about the bull market that we are trying to recover from today: “The relation between price-earnings ratios and subsequent returns appears to be moderately strong, though there are questions about its statistical significance, since there are only about twelve non-overlapping ten-year intervals in the 119 years’ worth of data. We believe, however, that the relation should be regarded as statistically significant….Long term investors would be well advised, individually, to stay mostly out of the market when it is high, as it is today, and to get into the market when it is low.”?
The Nobel prize winner continues: “The recent values of the price-earnings ratio, well over 40, are far outside the historical range of price-earnings ratios. If one were to locate such a price-earnings ratio on the horizontal axis, it would be off the chart altogether. It is a matter of judgment to say, from the data shown in Figure 1.3, what predicted return the relationship suggests over the succeeding ten years; the answer depends on whether one fits a straight line or a curve to the scatter, and since the 2000 price-earnings ratio is outside the historical range the shape of the curve can matter a lot. Suffice it to say that the diagram suggests substantially negative returns, on average, for the next ten years.”?
Shiller is speaking carefully here. That’s of course a good thing. However, I also detect a hesitance to state things as clearly as they need to be stated for people to understand how deep the problem is that we created by permitting the bull market of the 1990s to get so out of control.
Why didn’t he tell us the losses predicted by the horrible P/E10 number? He says that there is some judgment involved in identifying the proper prediction. That makes sense. The 44 P/E10 value was not just an outlier, it was a super outlier. It was a far, far higher number than any we have ever seen before in U.S. history. So, yes, it might be hard to say (and certainly it would be hard to accept) what result might follow. But surely we are better off knowing the details. Surely he should have told us the best and worst scenarios suggested by that number.
I am a little thrown by the statement that “the diagram suggests substantially negative returns, on average, for the next ten years.” Shiller never overstates negative findings, he makes it a consistent practice to understate them. I know that a regression analysis predicts a most likely 10-year annualized return starting from 2000 of a negative 1 percent real. That’s a shocking number given that it is seven percentage points worse than the usual annual return for stocks (and it applies for 10 years running) and five percentage points worse than the return that was available at the time from risk-free asset classes like TIPS and IBonds. But I wouldn’t call a return of a negative 1 percent real for 10 years running “substantially negative returns, on average, for the next 10 years.”
My biggest concern is over Shiller’s reluctance to offer hard numbers. I view the primary purpose of his work as offering a warning to investors of the dangers of not paying sufficient attention to valuations when deciding on their stock allocations. Shiller obviously understands that most investors are inclined to ignore such warnings (otherwise the P/E10 value would never have reached 44). When people show an inclination to ignore warnings, it is imperative that we all pull together to present them in language sufficiently bold and firm and strong as to be hard to ignore.
Say that we were warning people of the dangers of smoking. We wouldn’t say “Oh, smoking might in some cases do a little bit of harm but there’s a judgment call as to how much harm it causes, so we won’t spell out any details.” Or say that the police were deciding on a policy of when to enforce speed limits. They wouldn’t decide to give tickets to those driving ten miles over the speed limit because they know that that is a bit dangerous but then to ignore cases where drivers are driving 40 miles over the speed limit because those cases are so rare that it hard to say with precision how dangerous it is to drive at those speeds.
We elected as a society to go to places we have never gone before re stock prices in the late 1990s. It was an extremely irresponsible thing to do. We cannot today say precisely how irresponsible. But we certainly can say that through our irresponsibility we brought on the most dangerous time to be a stock investor in U.S. history. It is shameful that we permitted such wildly outlier valuation levels to evidence themselves. We should not sugarcoat the message even a tiny bit. It is by talking straight about the horrors of overvaluation that we develop the fortitude to avoid causing such financial wreckage in the future.