Valuation-Informed Indexing #265
by Rob Bennett
A fellow named “Douglas Greenburg” in San Francisco wrote a Letter to the Editor in response to Robert Shiller’s recent article (Rising Anxiety That Stocks Are Overpriced) that makes a point about Shiller’s work that I believe merits more attention.
Greenburg wrote: “Thank you so much, Robert Shiller. For all the illumination you have provided in housing, equities and markets generally. I’ve been a tremendous fan. And have even changed my tax law practice because of you (focusing not just on financial details but on the psychology of the clients as well).”
That’s precisely on the mark. People don’t get this. They think of Shiller as another guy who offers tips on how to do well in the stock market. He is so much more than that. P/E10 is an amazing concoction. It is a metric that tells us how emotional the market is at any given time. It is like a thermometer that tells us not how hot it is outside but how irrational we all have become inside. There’s never been anything like this. It is an amazing advance.
We’re all crazy. I won’t win any popularity awards saying that. But it’s so. WE ALL ARE IRRATIONAL. Irrationality is part of human nature. So we cannot escape it. But we do need to cope with the reality. It is our irrationality that makes stocks a risky asset class. So we have to face up to our irrationality if we are to learn how to invest effectively in stocks.
P/E10 makes it possible for the first time in history for us to do so. When the P/E10 is 15, we are being rational (in an overall sense) in our pricing of stocks. When the P/E10 is 8, we are being insanely pessimistic in our pricing of stocks. When the P/E10 is 28, we are being insanely optimistic in our pricing of stocks. The long-term return you get from investing in stocks is far better when you buy them at a P/E10 level of 8 than it is when you buy them at a P/E10 level of 28. P/E10 is the price-tag of stocks. Knowing the P/E10 and how to change your stock allocation in response to it is 80 percent of the stock-investing game. P/E10 is an amazing tool!
People don’t like using it. People don’t like hearing about it. There’s a lot of resistance to the idea of changing your stock allocation in response to changes in the P/E10 level, despite the mountain of research showing how much it improves results.
But what would you expect? People who are behaving in a crazy manner hate being told that they are behaving in a crazy manner. If we were all rational, we would all embrace P/E10 as the solution to our stock-investing problems. But today’s P/E10 tells us that we are not even a tiny bit rational today in our thinking about how stock investing works. So naturally we evidence reluctance to embrace this amazing tool.
Greenburg makes a great point when he notes that Shiller’s work has showed him that he needs to focus “not just on the financial details but on the psychology of the clients as well.” Professionals in finance-related fields have long emphasized the financial details. It impresses clients when they do so. We all respect numbers. We tend to respect professionals who are skilled at manipulating numbers.
But the psychological factors referred to by Greenburg are often of far more consequence. How many Buy-and-Holders will be able to stick with their high stock allocations if the P/E10 level drops to 8 or lower (as it has in every earlier secular bear market in U.S. history)? Most of today’s investors have only lived at times in which the media was pumping out a pro-stock message night and day. That won’t be the case following the next price crash. The message that we will be hearing then will be that most middle-class people probably shouldn’t be in stocks at all. How many investors will be able to keep the Buy-and-Hold faith in such circumstances?
Few will be able to do so. Which means that the core logic of the Buy-and-Hold strategy will fail for most. Professionals should be helping their clients come to terms with the emotional realities that make it a far-fetched bet that Buy-and-Hold will work out well for most. But most today stick to recitation of the numbers that make it appear for a time that sticking with a high stock allocation through a brutal secular bear market is a realistic possibility for most.
I have been presenting the case against Buy-and-Hold at internet discussion boards and blogs for 13 years now. It amazes me how emotional Buy-and-Hold investors get when their strategy is challenged. Yet rarely do I see articles appear that comment on this omni-present reality. Why? I consider it one of the most glaring deficiencies of Buy-and-Hold that it makes the investors who follow it so intensely emotional. In fact, the day I abandoned Buy-and-Hold as hopeless was a day in which a discussion-board poster who had been a good friend of mine in earlier times threatened to kill my wife and children if I continued to post about the errors in the Old School Safe-Witdrawal-Rate studies (which the Buy-and-Holders defended at the time but acknowledge are in error today) and I watched 200 Buy-and-Holders endorse his post. Huh?
I have come to believe that gaining control of one’s emotions is 80 percent of the stock investing story. The research shows that those who are able to keep their heads enough to lower their stock allocations when prices reach insanely high levels never do poorly in the long run. Getting valuations (which are of course just numbers that evidence investor emotions) right is so important that investors can do fine if they get every other element of the investor story wrong so long as they get that one right. And of course it works the other way around as well. Get everything else right and get valuations/emotions wrong and your odds of doing well in the long term are not at all good.
Focusing on emotions is the future of investing analysis. Shiller’s revolutionary findings will in time change the nature of what it means to offer effective investing advice in a profound way. We all should be focusing not on numbers but on what makes investors tick and on how they can come to rein in the impulses that made stock investing a risky endeavor in earlier times in which we knew less about how investing works in the real world.
Rob Bennett’s bio is here.