Valuation-Informed Indexing #341

By Rob Bennett

Shiller didn’t show that valuations affect long-term returns when valuations are in bubble territory. He showed that valuations ALWAYS affect long-term returns. Valuations matter when prices are low. Valuations matter when prices are moderate. Valuations matter when prices are high. Valuations ALWAYS matter.

 

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Investors need to accept a paradigm change to appreciate this point. Most of us think of valuations as a special case. The ordinary thing is to be highly invested in stocks. Occasionally valuations reach such high levels that it might make sense to lower one’s stock allocation a bit. The valuations question, for most of us, is a matter of determining whether now is one of those rare times and a matter of determining how much of an allocation shift is appropriate.

That’s the wrong way to think about things. The valuation level for stocks is the price of stocks. Price is something that needs to be taken into consideration in every possible strategic determination. You need to consider the effect of valuations when determining your safe withdrawal rate. It doesn’t matter whether valuations are low, moderate or high when you do this. You simply cannot get the numbers right without taking the valuation level that applies on the day the retirement begins into consideration. And of course it is not possible to do effective financial planning without getting the numbers right.

Or say that you just want to know how well you are doing financially. The size of your stock portfolio is a big part of the answer to that question. But holding a $100,000 stock portfolio at a time when the P/E10 level is 8 is not the same thing as holding a $100,000 stock portfolio at a time when the P/E10 level is 32. The former portfolio obviously holds four times the value. The investor who holds a $100,000 stock portfolio at a time when the P/E10 value is 8 is in much better shape.
Or say that you want to know how the economy will be doing in coming years because you are starting a business or because you expect to be leaving the career you are in and are concerned whether opportunities will be widely available or not a few years into the future. If stocks are priced at rock-bottom prices, it is almost certain that valuations will be moving upward over the next five or ten years. When valuations remain constant, the return on stocks is 6.5 percent real. So the return is greater than that at times when valuations are rising. When returns are strong, millions of people have more money to spend and the economy expands. So knowing the P/E10  level that applies at a particular point in time and possessing an understanding of the far-reaching implications of Shiler’s “revolutionary” (his word) research findings tells you more about the future economic picture than do most of the conventional economic indicators.

Valuations affect every aspect of the stock investing experience. Too often discussions of valuations are rooted in a presumption that the purpose is to guess when valuations are going to turn and to profit from the guessing game. That the one thing that Shiiller’s research findings do not help the investor to do; short-term price changes are highly unpredictable. The power of Shiller’s finding that valuations affect long-term returns is that it illuminates every question faced by investors other than the silly guessing-game one that garners so much attention.


Say that you were thinking of buying a car. You obviously would ask the dealer for the price. You don’t do that for a single purpose. Knowing the price serves multiple purposes. It tells you whether you can afford the car or not. It also informs you how you may need to adjust your desires to identify the car that is right for you; by comparing the prices of two cars, you can see how much one feature y
ou like adds to the overall cost and assess whether that feature is worth the cost associated with it. Knowing the price attached to a used car with a specified number of miles on it signals how new of a car you can afford. Knowing the price of a car advances your car purchase project in many ways and the same is true with knowing the valuation level for stocks — identifying the P/E10 level tells you all sorts of things that you need to know to make an intelligent investment decision.

Knowing the valuation level for stocks matters every bit as much when valuations are low as it does when valuations are sky high. People hesitate to buy stocks when prices are low. Low prices usually appear as the result of crashes that scare most investors out of the market. But they steady the nerves of those who understand the message being conveyed by the low prices. When the P/E10 level is at rock-bottom lows, the potential for loss on a stock investment is very small and the potential for large long-term gains is high. The risk/reward ratio favors the investor to an extent that it does not at times of moderate or high prices. You don’t want to follow valuation trends just to know when to jump out of stocks but to know when to increase your stock allocation as well.

Valuations always affect long-term returns. Always. Valuations matter when prices are low, moderate and high. Valuations always matter. Valuations are not something you should be tuning into only when prices are off the charts on the high side. Think about valuations all the time and it will become a habit to do so and taking valuations into consideration at times of high prices will be part of a holistic practice and will no longer be the panicky practice that it is for too many of today’s investors.

Rob’s bio is here.