by Rob Bennett
The word “overvaluation” trips off the tongue without us stopping to think what it signifies. Stocks were priced at three times fair value (according to the P/E10 metric — the valuation metric used by Yale Professor Robert Shiller and recommended by Benjamin Graham in the 1930s) at the top of the bull. Here is a list of some implications that logically follow:
1) Every stock investor was reading a number at the bottom of the last page of his portfolio statement that was wildly off from the number that represented his real portfolio value. The investor who thought that he possessed $100,000 in stock wealth really possessed only $35,000 in stock wealth. The investor who thought that he possessed $300,000 in stock wealth really possessed only $100,000 in stock wealth. The investor who thought that he possessed $1 million in stock wealth really only possessed $350,000 in stock wealth;
2) The calculators that people use to determine whether their saving efforts are on track were offering unjustified reassurances. These calculators do not contain valuation adjustments. So they assume average annual returns of something in the neighborhood of 6.5 percent real. But stocks obviously cannot provide the same average long-term return starting from all possible valuation levels. A regression analysis shows that the most likely 10-year return starting from the valuation levels that applied in 2000 is a negative number. So the calculators were telling investors that their saving efforts were on track when in fact they were wildly off track. Accurate calculators would have assumed returns of less than zero for the next 10 years;
3) The calculators that people use to plan their retirements also reported bad numbers. Most retirement calculators tell users that the safe withdrawal rate (the inflation-adjusted portfolio percentage that can be taken out to finance living expenses each year) is always 4 percent. An analysis that includes a valuations adjustment shows that the safe withdrawal rate can drop to as low as 2 percent (at times of high valuations) and can rise to as high as 9 percent (at times of low valuations). The incorrect numbers that were reported during the wild bull will cause millions of failed retirements in days to come, in the event that stocks perform in the future anything at all as they have always performed in the past;
4) The promotion of Buy-and-Hold investing strategies caused a huge transfer of wealth from young investors to old investors. Old investors enjoyed the run-up in prices that took us from a P/E10 of 8 in 1982 to a P/E10 of 42 in 2000. Their losses in subsequent years are really just a paying back of unearned gains from earlier days. But investors who first started buying stocks at any time from 2000 forward have experienced losses without having first enjoyed gains and will continue to feel the pain of those losses as they miss out on the benefits of compounding returns on the loss amounts for many years to come;
5) The bull market was the primary cause of the economic crisis. The dollar amount of overvaluation in 2000 was $12 trillion. Since stock prices always revert to the mean over time–periods of roughly 10 years, our economy was due to see losses of consumer wealth of roughly that amount regardless of anything that happened with mortgages or with bankers. It is hard to imagine how a consumer economy could fail to collapse under that sort of financial pressure;
6) Investors who regularly put money into their 401(k) accounts were in reality directing only one-third of the amounts deposited to the purchase of stocks; the other two-thirds was being directed to the purchase of cotton-candy nothingness fated to go “Poof!’ over the course of the next 10 years or so. Investors putting $3,000 into their accounts each month were obtaining in return only $1,000 worth of assets likely to yield a return of something in the neighborhood of 6.5 percent real for the next 10 years or so;
7) Huge amounts of economic resources were misdirected because of the widespread confusion over the significance of massive stock overvaluation. Businesses selling high-priced cars, big houses, expensive vacations and other luxury goods earned higher profits than they would have earned had the American consumer possessed a better understanding of his true net worth. Conversely, businesses that provided low-cost products and services were put at a disadvantage because consumers were led to believe by the numbers on their portfolio statements that there was no particular need for them to be frugal at this time.
There is an old saying that argues that a little bit of knowledge can be dangerous. We have in recent decades gained the little bit of knowledge it took to begin analyzing the historical stock-return data. In the early days of this project, we did not possess the understanding needed to appreciate that the effect of valuations always must be taken into account for such analyses to bear good fruit. We are now paying the price for moving ahead too quickly and with too much confidence without thinking through carefully enough what we need to do to proceed responsibly with this important project.