Valuation-Informed Indexing #356 on the topic of why stock investing works and the Shiller PE ratio

by Rob Bennett

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I only write about valuations. There are lots of people who have better informed takes on every investing subject other than valuations and so my view is that I should leave those subjects to others. I write about valuations because I believe that it is the great unexplored subject in stock investing and so we all should be doing what we can to launch discussions about it.

That said, it’s not a bad idea for my to remind myself from time to time that, as important as valuations are, understanding valuations alone will not provide an investor with a complete understanding of how stock investing works. If valuation-informed investors start to think that valuations are the only thing that matters, they will be disappointed in the results they obtain and may in time come to lose confidence in their valuation-centered strategies.

If you adjust your stock allocation in response to big valuation shifts, you need to make an assumption as to the real (that is, excluding valuations) return on stocks. The obvious number for those investing in broad U.S. stock indexes to use is 6.5 percent real; for 145 years now, that has been the average stock return. When we see returns higher than that for many years running, we know to expect reduced returns on a going-forward basis and, when we see returns lower than that for many years running, we know to expect enhanced returns on a going-forward basis.

Writing Skills stock investing works
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The reality, of course, is that the 6.5 percent figure is not etched in stone. It could be that the U.S. economic system has become more productive than it has ever been before in recent decades and that on a going forward basis the long-term return will be 7.0 percent real. Or of course things could go the other way and the future long-term return could be 6.0 percent real.

Even that statement highlights the danger of ignoring valuations. If you don’t take valuations into consideration when determining the true value of your portfolio, you will be fooled into thinking that annual gains of 20 percent or 30 percent or 40 percent are real and thereby mess up your financial planning efforts in a serious way. Those who presume that the 6.5 percent long-term average return will continue to apply manage to avoid falling into the trap of believing that whatever numbers are generated by widespread irrational exuberance are real.

But the average long-term return really can change. The benefit of using the historical return as one’s assumption for the going-forward return is that it is an objectively generated rule of thumb. We all want to be able to retire as soon as possible. Left to our own devices, I suspect that a lot more of us would assume a going-forward return that is higher than 6.5 percent real than would assume a going-forward return that is lower than 6.5 percent real. Still, those who have strong beliefs that economic changes justify different assumptions are being entirely reasonable in using those assumptions in their asset-allocation decision-making process.

Another non-valuation factor that should be kept in mind is the government’s role in determining stock price changes. Good information on the extent to which the government tries to keep stock prices from falling too hard and too quickly is hard to come by. So it is not possible to talk about this factor in a  fully informed way. But I believe it is fair to say that the level of government involvement is greater today than it was for most of the 145 years of stock market history for which we have good records. An increasing government role changes the rules of the game. Those using historical data on the effect of valuations to construct their strategies need to keep that in mind.

Robert Shiller suggested in early 2009 that even though stock investing works, investors might want to keep out of stocks until the P/E10 level dropped below 10. That advice was rooted in the historical reality that we have never seen a secular bear market come to an end until the P/E10 level dropped to 8 or lower. But it may be that the Federal Reserve took steps to keep stock prices from falling as low as they would have naturally fallen for fear that further price drops would have brought on an economic depression. It may be that the old rules just don’t apply anymore. Valuation-Informed investors need to keep the possibility in mind at all times.

Knowing everything there is to know about valuations also will not tell you when price drops will come. Shiller famously predicted in late 1996 that investors going with heavy stock allocations would live to regret the mantra of stock investing works within 10 years. The reality, of course, is that we did not see a price crash until 12 years later. My view is that Shiller was more right than wrong and that he performed a great public service by letting us know stock prices in 1996 were getting so out of hand that they were on the way to causing an economic crisis. The reality remains, however, that his prediction did not get things precisely right.

Valuation-Informed investors need to exercise humility in the execution of all their strategies. We know a great deal more today about how stock investing works in the real world than we knew in the days before Shiller’s “revolutionary” (his word) 1981 finding that valuations affect long-term returns. But there is still much that we do not know. We can best take advantage of what we now do know by always keeping in mind the limits to today’s knowledge that also very much apply.

Rob’s bio is here.