by Rob Bennett
Stock prices are volatile.
It’s always been so. Everybody knows it.
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But must it always be so?
There was a time when there were no cars or phones or electricity or computers. It was because we learned stuff that we were able to bring these life-changing inventions into being. Could it be that we are in the process of learning things about investing that will someday permit us to look at price volatility as a thing of the past? That’s what I think.
I am not talking about individual stocks. There are scores of factors that affect the price of an individual stock. So individual stock prices will always remain volatile, responding daily to new information bits relating to any of those scores of factors.
Index funds are different. When you buy a broad index fund, you no longer need concern yourself with whether good managers will remain in place or whether a moat will remain in place or whether new products will be coming down the pipeline as expected. There will be some companies that will keep their good managers and some who will lose them. The effect of positive developments will counter the effect of negative developments. Neither good nor bad developments of this type influence the price of the overall index.
The productivity of the economy affects the price of an index fund. In the United States, we have long enjoyed sufficient productivity to finance an average long-term return of 6.5 percent real. It could be that on a going forward basis the number will be a bit more than that or a bit less than that. However, given that our economy is a stable and mature one, the change is not likely to be big. The average long-term return on a going forward basis is likely to be somewhere between 6 percent real and 7 percent real. So this factor is close to being a known quantity.
What else is there? The other factor is my great bugaboo — valuations.
The average long-term return has for a long time been 6.5 percent real. But more often than not the average return does not apply; Prices often drop to levels far below fair value, as they did in the mid-1970s. From those sorts of starting points, we see long-term returns much higher than 6.5 percent. And prices often rise to levels far above fair value, as they did in the mid-1990s. From those sorts of starting points, we see long-term returns much lower than 6.5 percent real.
So for the first few decades in which they have been available, the prices of index funds have been nearly as volatile as the prices of individual stocks. But that may be about to change.
Index-fund prices are not random. Yale Economics Professor Robert Shiller reports at his web site on the valuation levels that have applied for the S&P 500 going back to 1870. The S&P returns have followed a general pattern for that entire time period: The valuation level goes up for a long time and then down for a long time and then the cycle begins anew. We are now on the downward slope of the most recent cycle. If the long-running pattern continues to evidence itself, we will see another crash that will bring stock prices to one-half fair value (a P/E10 level of about 7) and then valuation levels will begin working their way back up.
A drop to a P/E10 level of 7 translates into a price drop of over 60 percent from where we stand today. That’s going to hurt. That’s going to get a lot of people’s attention. This will be the first time since index funds became widely available that middle-class investors will have experienced such a hit. I think that this big hit is going to get people thinking about the potential of indexing to change investing in fundamental ways.
With indexes, price volatility is optional.
We know from Shiller’s work that valuation levels predict long-term index-fund returns; starting from times of high prices, returns are low; and, starting from times of low prices, returns are high. That means that the value proposition of owning stocks is not a constant but a varying thing. Stocks offer a better deal when prices are low or moderate than they do when prices are high.
Investors should be changing their stock allocations in response to valuation shifts. Some already do this. But not many. What’s holding people back today is their confidence in the Buy-and-Hold Model for understanding how stock investing works. It is a cardinal principle of the Buy-and-Hold Model that timing doesn’t work.
But it does! Shiller’s work shows this. I have seen a good bit of erosion in confidence in Buy-and-Hold since the crash of 2008. Another crash is going to leave middle-class investors entirely disenchanted and on the lookout for new strategies. An obvious option now available to those who desire the high returns associated with stock investing without taking on the risk of losing money in a crash is investing heavily in index funds only at times of low or moderate prices. There has never been a stock crash of lasting significance that began at a time when stocks were fairly priced or low-priced.
If large numbers of investors adopt a practice of changing their stock allocations in response to valuation shifts, there will never again be valuation shifts. So long as investors engage in long-term market timing, market prices are self-correcting (each valuation increase brings on sales, which bring prices back to fair value levels). In the wake of the next crash, valuation levels might remain near fair-value levels for many years to come.
I am describing an historic change — non-volatile stock prices. Tomorrow’s investors will have available to them the high returns associated with stocks with the low risk (non-volatile stocks are low-risk stocks) associated with asset classes paying far lower returns. Investor heaven!
Welcome to the Brave New World of stock investing. If only we didn’t need to live through another stock crash to get there!
Rob Bennett thinks we should stop kidding ourselves about the Efficient Market Theory. His bio is here.