Valuation-Informed Indexing #263
by Rob Bennett
I rank Robert Shiller as the most important investing analyst of all time. So, when the thought of giving this column entry the headline that you see above popped into my head, I hesitated. I looked up the word to see precisely what it signifies to say that something is “disingenuous.” The answer that came back is: “not candid or sincere, typically by pretending that one knows less about something than one really does.” I concluded that the term fits.
I don’t believe that Shiller is being entirely disingenuous. His 1981 finding that valuations affect long-term returns “revolutionized” (Shiller’s word) our understanding of how stock investing works. We need a national debate on the implications of Shiller’s findings before any of us will be able to fully appreciate the implications of the new model. We are all suffering cognitive dissonance. That includes Bogle. That includes Shiller. That includes me.
So I hope that my claim that Shiller is being disingenuous will not be perceived as excessively harsh. Still, I think the claim needs to be advanced. People look to Shiller as the #1 expert on Valuation-Informed Indexing. When he says things that don’t entirely add up, he does harm to the efforts of all of us who want to see Valuation-Informed Indexing become dominant over Buy-and-Hold.
Shiller said in a recent article titled Rising Anxiety that Stocks Are Overpriced that: “The average Cyclically Adjusted Price/Earnings Ratio [P/E10) between 1881 and 2015 in the United States is 17; in July, it reached 27. Levels higher than that have occurred very few times, including the years surrounding the stock market peaks of 1929, 2000 and 2007. In all three of these instances, the stock market eventually collapsed….In two other episodes, CAPE was very high — following sharp increases in the preceding couple of years — when the Standard & Poor’s 500-stock index fell 10 percent in just five days. One was in April 2000, when CAPE stood at 44, and that was followed by a huge crash that eventually took the S.&P 500 further down by an additional 43 percent by 2003. The other was in August 1998. At that point, CAPE was around 35. This was during the Russian debt crisis, and the market roared back while President Bill Clinton was in Moscow dealing with the crisis….It is entirely plausible that the shaking of investor complacency in recent days will, despite intermittent rebounds, take the market down significantly and within a year or two restore CAPE ratios to historical averages….Or maybe this could be another 1998. We have no statistical proof. We are in a rare and anxious ‘just don’t know’ situation, where the stock market is inherently risky because of unstable investor psychology.”
Most of what Shiller says here is both true and important. Yes, stocks are insanely overpriced. Yes, that makes stocks a dangerous investment class. Yes, we do not know whether stock prices will crash soon or not. The research-based support for these claims is overwhelming.
What bugs me is not so much the content of what Shiller is saying as the manner in which he is saying it. Most investors don’t care about theory; they want to know what to do with their money. What is Shiller telling us to do? Is he saying that we should lower our stock allocations because prices are insanely high? Or is he saying that we do not need to lower our stock allocations because short-term predictions don’t work?
He is saying both of these things. And that message is a highly confusing one for most investors.
Look at the last sentence of the material that I quoted from Shiller’s article. He says: “We are in a rare and anxious ‘just don’t know’ situation, where the stock market is inherently risky because of unstable investor psychology.” Huh? What does that mean? The stock market is “risky.” But we are also in a “just don’t know” situation. Can both things possibly be true at the same time?
If the stock market is more risky than usual, investors should be lowering their stock allocations. We all want to keep our risk profiles roughly constant. So, when the market gets more risky, we need to go with lower stock allocations. Does that not follow?
So why does Shiller say that we are in a “just don’t know” situation? We do know. We know that stocks are riskier than usual. We know that we need to lower our stock allocations. We know what we need to know.
We don’t know precisely when the crash is going to arrive. Shiller is right about that and he is right to point that out. If he failed to point that out and then stocks did not crash soon, people would say that his prediction “failed.” We can only predict the long-term and so it is important to tell people that P/E10 cannot be used to make short-term predictions. But it is not at all true that we are in a “just don’t know” situation. Risk is high. So we know that investors should be lowering their stock allocations.
This manner of speaking about the power of P/E10 to predict long-term returns is common. It hurts the cause. Investors hear that we cannot predict the short-term and pick up on suggestions that we don’t know what we need to know and conclude that it is okay to fail to stick with their high stock allocations a bit longer. Remember, most investors want to believe that the numbers that they see on their portfolio statements at times of high valuations are real. Shiller is saying things in a manner that permits investors who want to continue to believe in bull-market fantasies to do so. That’s unfortunate.
We know what we need to know. We know that stocks are more risky today than they would be if prices were more reasonable and that we need to lower our stocks allocations as a consequence. That’s how I would say it. I would make an effort to state the message in a manner that did not permit investors going with high stock allocations today to miss what was being said about what they need to do in response to today’s dangerous stock prices.
Rob Bennett’s bio is here.