Valuation-Informed Indexing #256

by Rob Bennett

My friend Wade Pfau has written an important article on Valuation-Informed Indexing that I encourage you to read in full. The article is titled: Is High CAPE Cause for Alarm? Part Two: Valuation-Based Asset Allocation.

The article refers to me directly. It states: “We have historical evidence to suggest that mean reversion can be expected at some point, but it most certainly cannot be predicted. Since the precise timing of mean reversion is entirely random and unpredictable, expecting the result to occur in the short-term is unwise. One internet blogger has been using PE10 to predict a 65% drop in the S&P 500 by the end of 2015. This is not how the concept should be applied.”

I am the internet blogger being referred to here. There are points made in that paragraph re which I am in agreement with Wade. But I am very much NOT in agreement with him re the question of whether we should be expecting a price crash of roughly 65 percent by the end of 2016 (I once predicted that we would see the crash by the end of 2015, but that was a number of years back — I have been predicting it by the end of 2016 for a long time now). The question of whether there comes a time when relatively short-term predictions are feasible is an important one and one that needs to be much more widely discussed.

I agree 100 percent with Wade that mean reversion can be expected whenever prices get too far out of hand. I disagree with his statement that “it certainly cannot be predicted.” It is certainly true that there are limits to our ability to predict when mean reversion will take place. But it is not true that no effective predictions are possible. In fact, it is dangerous and irresponsible (in my view!) to pretend that this is the case.

Even the statement that mean reversion always takes place is a prediction. It is not at all a precise prediction. But it is a prediction all the same. The question is not: Are predictions possible? The question is: What sorts of predictions are possible?

I predict that we will see a price crash by the end of 2016. That is only 18 months out and so it is a short-term prediction. The general rule is indeed that short-term predictions do not work. The general rule is that only predictions that go ten years out work. So, looking at things on a surface level, what Wade is saying is in tune with that the research shows.

But there’s a complication.

The P/E10 level peaked in January 2000. The research showed at that time that we would see a crash within 10 years. We of course did indeed see a crash in that time-period — prices fell dramatically in late 2008. So that prediction worked.

But the bull/bear cycle that began in 1982 did not resolve with the 2008 crash. There has never been a bull/bear cycle that ended before the P/E10 level dropped to 8 or lower. This is why Robert Shiller was telling people in early 2009 to stay out of stocks until the P/E10 level dropped below 10. We never got there. The Fed pumped money into the market to block it from falling below 13 and they have continued trying to hold off the deeper price crash that we need to experience before a new cycle can begin. We still have to go to 8 or below, which is a price drop of a bit more than 65 percent from where we stand today.

It’s important to know when we will see that price crash. The answer affects all sorts of things. It obviously affects the efforts of investors to finance their retirements. It also affects the economic recovery we all want to see. Each time prices crash investors lose trillions of dollars of pretend bull-market wealth. That means they cut back on spending. That means that hundreds of thousands of businesses fail. That means that millions of workers lose their jobs. This question of whether it is ever possible to make relatively short-term predictions of where stock prices are headed is a matter of great public policy import.

I do not feel comfortable making short-term predictions. I agree wholeheartedly with Wade that as a general rule “this is not how the concept should be applied.” But I have a big problem with holding back from making the 65-percent-crash-within-two-years prediction in the circumstances that apply today.

The first crash took place in September 2008. As a society we permitted P/E10 levels to reach such insanely high levels in the late 1990s that a single crash was not enough to bring prices to the levels they need to reach for the old bull/bear cycle (which dates back to 1982) to resolve itself and for a new one to begin. So there has to be another crash. Using the ten-year rule (which is the rule supported by the 145 years of historical data available to us today), we should be expecting that second crash by the end of 2018.

So I acknowledge that the prediction that I often put forward — that we will see the next crash by the end of 2016 — may not come through. It is hard to be precise about these things. Shiller famously was “wrong” about the prediction he made to the Federal Reserve that we would see the crash we saw in 2008 by the end of 2006. I put scare quotes around the word “wrong” because it is my view that Shiller was more right than wrong in his 1996 prediction. No, he didn’t get it precisely right. But he got it a lot more right than the many “experts” who were saying that there might not be a huge price to be paid for the insane price levels we saw in the late 1990s. I would rather be roughly right than wildly and irresponsibly wrong (as was just about every expert in this field not named “Shiller” back in 1996).

There are two reasons why I predict that we will see a crash by the end of 2016 rather than by the end of 2018 (the far safer prediction).

One reason is that a lot of my critics insist that I offer claims that can be verified as proof that the Valuation-Informed Indexing concept works. I always explain that precise predictions generally cannot be made. However, I do have some sympathy for their position. To say “there will be a crash someday because prices must revert to the mean but we have no idea when that will happen” is to say just about nothing. It is not fair for critics of Valuation-Informed Indexing to demand more precision than is possible. But it is also at least a little bit unfair for Valuation-Informed Indexers to refuse to offer any precision whatsoever. I think we should always employ caveats when we make predictions. But I think we also need to try to be a bit more specific than to say “there will be another crash someday.”

Valuation levels  have been headed downward for nearly 16 years. It’s been seven years since the first crash. Ten years is not the amount

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