by Rob Bennett
I often point out that a regression analysis of the historical stock-return data shows that, at the prices at which stocks were selling in January 2000, the most likely annualized 10-year return for stocks was a negative 1 percent real. Most investors interpret this as bad news for investors. In fact, many have told me that they have found such reports depressing.
There’s nothing to be depressed about. Low stock returns need not hurt you as an investor.
First, let’s consider why it is that most investors view a report that stocks are due to provide a poor long-term return as bad news. It’s because the Buy-and-Hold Model for understanding how stock investing works is today the dominant model. Under the Buy-and-Hold Model, a time-period in which stocks provide poor returns is bad news indeed.
The Buy-and-Hold Model posits that the return provided by an asset class is determined by how much risk is associated with investing in that asset class. Stocks generally provide high returns because stocks are a high-risk asset class, according to this model If this is so, investors hoping someday to be able to afford comfortable retirements need always to be invested heavily in stocks. To go with a low stock allocation is to forsake the risk which must be taken on by investors hoping to obtain appealing long-term returns.
The Valuation-Informed Investing Model rejects this line of thinking. Under the new model, there are two factors that determine the long-term return paid by stocks: (1) the productivity of the U.S. economy (our economy has been sufficiently productive to finance a long-term return for stocks of 6.5 percent real for as far back as we have records); and (2) the valuation level that applies on the day the stock purchase is made (stocks obviously pay higher returns starting from times when they are priced reasonably than they do starting from times when they are priced insanely high). Investors seeking high returns are not required to take on high levels of risk, under the Valuation-Informed Indexing Model. So there is no penalty associated with going with a low stock allocation or even a zero stock allocation for a time.
Valuation-Informed Indexers have opportunities available to them that are not available to Buy-and-Holders. Valuation-Informed Indexers are free to move their money to super-safe asset classes (TIPS, IBond and CDs) at times when stocks offer a poor value proposition.
In January 2000, TIPS were offering a guaranteed return of 4 percent real. That’s an amazing deal that Buy-and-Holders were reluctant to take advantage of because of their belief that it is a mistake not always to be invested in high-risk asset classes. Valuation-Informed Indexers were happy to take advantage of the wonderful deal being offered by TIPS. It is fair to say that the high valuations that applied for stocks were bad news for Buy-and-Holders because they ruled out the possibility of them obtaining a good return on their retirement money. But those high valuations presented no problem for Valuation-Informed Indexers, who simply moved their money to a place where they could obtain an exciting value proposition.
There is always an exciting value proposition somewhere. It is a logical impossibility that this would not be so.
It is not a coincidence that TIPS were offering a mouthwateringly great return just at the time when the likely long-term return on stocks was the lowest it has ever been in history. The return on TIPS is determined by investor demand for them; at times when demand is low, the return promised has to be high to attract investors. Demand for stocks was off the charts in January 2000; the insane valuations that applied at the time would not have been possible had this not been so. The same factor that caused the low stock returns (irrational exuberance for stocks) also caused the high TIPS returns (by creating such great investor demand for stocks that there was little demand left to be directed to TIPS).
It always works this way. Irrational demand for one asset class translates into irrationally great opportunities to invest in other asset classes. So long as the investor remains open to taking advantage of whatever opportunities present themselves (Buy-and-Holders do not do this), he cannot go wrong.
What about today? The return on TIPS is not nearly as enticing today.Yet the full reality is that TIPS probably offer a more appealing deal today than they did in January 2000.
When stock prices go to double fair value, they always move in the following years to one-half of fair value. There is not one exception in the historical record. Why does it work like this? High valuations create trillions in pretend money that investors count on and then watch disappear in the crash that inevitably follows any period of irrational exuberance. Investor depression over the loss of their pretend wealth causes them to cut back on spending and thereby cause an economic crisis. The economic crisis causes stock prices to fall to levels as irrational on the low side as they had been irrational on the high side a few years earlier.
When the P/E10 level is 8, the most likely 10-year annualized return is 15 percent real. Money put into TIPS today will be available to invest in stocks paying amazing returns in only a few years. It is not right to look only at the direct return being paid on TIPS when assessing the long-term value proposition of TIPS. You must also take into account the reality that money invested in TIPS will be available to invest in stocks (as money invested in stocks will not be) when stock prices are mouthwateringly great.
Do you see how it works?
It is valuations that tell you whether stocks will be offering a good return on a going forward basis or not. When stocks offer a good return, you obviously should be invested in stocks. When stocks do not offer a good return, it’s always because valuations are high. But high valuations are not a permanent reality. High valuations cause crashes and crashes cause low valuations and low valuations translate into high returns on a going forward basis. Whenever the long-term value proposition for stocks is poor, it is in the process of becoming very strong indeed. The smart strategic choice when the long-term value proposition for stocks is poor is to be invested in asset classes where the value of your portfolio is retained until the time when stocks again offer a strong value proposition.
Why do TIPS pay a lower return today than they did in 2000? Because we have already experienced one stock crash. That made stocks less appealing. Demand for stocks is not as strong today and so the demand for TIPS is greater and the return paid on TIPS is smaller. The other side of the story is that we are closer to the day when stocks will again offer a mouthwateringly great long-term value proposition. If you bought TIPS in 2000, you would need to be willing to hold them for a long time before being able to move the money to stocks paying an attractive return. We are today 11 years closer to the day when stocks will again be the place to be.
It is never possible for all asset classes to offer a poor long-term value proposition. It can seem that way if you consider only direct returns. But the forces that cause stocks to offer poor returns set in motion developments that will cause stocks to offer strong returns a few years down the road. Investors taking a long-term perspective always have a good place to put their money. More often than not, it’s stocks. When it’s not, it’s the super-safe asset classes that permit us to retain the value of our wealth while we wait for the market to work through the cycle of irrational exuberance/irrational depression that must be completed before stocks can again become worth owning.