by Rob Bennett
We learned in 1981 that valuations affect long-term returns and that Buy-and-Hold (sticking with the same stock allocation at all valuation levels) thus cannot work for the long-term investor. Yet most experts and most investors continue to stick with the long-discredited model. Why?
The shift to Valuation-Informed Indexing is a big one. It’s hard to accept that we got it wrong before. And it’s hard even to consider the implications that follow from acknowledging that long-term returns are predictable. The shift to the new investing model is an exciting development. But it’s also a scary one. Many of us are less than enthusiastic about the change and emotionally resistant to it.
Last week’s column examined seven rationalizations often offered for sticking with the conventional advice. This week’s column looks at an additional seven rationalizations. I will consider the final seven rationalizations in next week’s column.
Rationalization #8: There’s Not Enough Historical Data for Investing Research to Be of Any Value. This is an exceedingly strange claim for Buy-and-Holders to be making. All Buy-and-Hold claims are rooted in analysis of the historical data! If there is not enough data to justify confidence in Shiller’s claims, there is not enough data to justify confidence in Fama’s claims. It is reasonable to argue that it would be good to have more historical data to examine. And it is reasonable to argue that, given the limited data we have to work with, it is not prudent to become dogmatic re any findings developed from analysis of the data. But it is not reasonable to argue that there is enough data to support Buy-and-Hold claims but not claims rooted in Shiller’s finding that valuations affect long-term returns.
Rationalization #9: It Does Not Matter That Stock Returns Are Better Starting from Times of Low or Moderate Valuations SInce In No Case Can Less Risky Asset Classes Offer Returns Better Than Stocks. This claim follows from the premises in which the Buy-and-Hold Model is rooted. Buy-and-Holders believe that stocks pay high returns because they are risky and those who invest in them are being compensated for taking on more risk than is being taken on by those who invest in super-safe asset classes like Treasury Inflation-Protected Securities (TIPS), IBonds, and Certificates of Deposit (CDs). The problem with the claim is that it is circular. It is true if the premises of the Buy-and-Hold Model hold up. But Shiller’s findings throw doubt on those premises. The data does not support the Buy-and-Hold belief that investors are always compensated for risk. A regression analysis of the historical data shows that the most likely annualized 10-year return for stocks in 2000 was a negative 1 percent real while the guaranteed return on TIPS at the time was 4 percent real. The Shiller model (Valuation-Informed Indexing) is rooted in a belief that investors are compensated not for taking on real risk (stocks were risky as all get-out in 2000 but the compensation being paid to stock investors was less than zero) but for taking on perceived risk (stocks were so popular in 2000 that most investors viewed it as risky to put their retirement money in a super-safe asset class paying “only” 4 percent real.
Rationalization #10: No One Knows the Future. Many investors reject out of hand the idea that stock returns can be predicted. It sounds too good to be true. Who has a crystal ball? But the returns of broad index funds are determined by the productivity of the U.S. economy and the U.S. economy has been sufficiently productive to finance an average annual return for stockholders of about 6.5 percent real for as far back as we have records. Is it really so unreasonable to believe that this will at least more or less continue to be the case? If this continues to be the case, all that remains for those wanting to make effective predictions of long-term returns is to check the valuation level that applies at the time the index fund is purchased and to make the necessary adjustment to the 6.5 percent figure. Some things are predictable. For example, weather reports predict the weather effectively. No one claims that those making weather predictions are relying on crystal balls.
Rationalization #11: P/E1 Has a Mixed Record as a Return Prediction Tool. P/E1 does indeed have a mixed record. That’s why those who believe that long-term returns can be predicted do not employ P/E1 as their valuation metric. They use P/E10 (Shiller’s choice) or Tobin’s Q or some other metric that both makes theoretical sense (P/E1 is flawed from a theoretical perspective) and has a good track record. Pointing out that P/E1 often does not serve as an effective valuation metric does not show that stock returns cannot be effectively predicted.
Rationalization #12: Even Shiller’s Model Does Not Permit Precise Predictions. This is an important caveat that those taking valuations into consideration when setting their stock allocations need to keep in mind, It is not a good reason for not taking valuations into consideration. Knowing some of what you would like to know is not as good as knowing all of what you would like to know, but it is better than knowing nothing of what you would like to know. Those who go with the same stock allocation at all times are investing as if valuations had no effect on future returns. We know with certainty that that is not so.
Rationalization #13: It’s Safer Not to Make Predictions. It feels safer for many, that much is so. However, the reality is that there is no neutral ground on this matter; those who do not change their stock allocations are making an implicit prediction that this will be the first time in history when valuations will not affect long-term returns. How else can we explain the reality that millions of investors invested heavily in stocks in 2000, when the data indicated that TIPS were likely to outperform stocks by 5 percentage points of return on average for each of the next 10 years? It was not safe to fail to make a prediction in that circumstance. And insane overvaluation is a circumstance that is certain to come into play sooner or later once a large number of investors comes to believe in Buy-and-Hold. There is no brake on stock prices once investors come to believe that they need not be concerned about high valuations.
Rationalization #14: If Returns Could be Effectively Predicted, Everyone Would Be Doing It. If investing were a 100 percent rational enterprise, it is true that everyone would be looking at return predictions before setting their stocks allocations. But if investing were a 100 percent rational enterprise, stocks would never become overvalued in the first place; the rational thing would be for investors to set stock prices at their proper level. So this argument is circular. It posits that “If investors were 100 percent rational, none of us would need to take investor irrationality into consideration when setting our stock allocations.” That’s a true but pointless claim in a world in which investor irrationality is so great as to permit the sorts of stock prices we saw from 1996 through 2008.