Valuation-Informed Indexing #33:
The Market Is Backward-Looking

<i>Valuation-Informed Indexing</i> #33:<br> The Market Is Backward-Looking

by Rob Bennett

The conventional wisdom is that the market is forward-looking. What investors are trying to figure out is — Where are stocks headed? They form an assessment of what they think is going to happen to the economy and that determines what prices they are willing to pay for stocks. As their assessments of future economic developments change, stock prices change with them. The stock price that applies on any particular day reflects the collective assessment of millions of investors placing their bets on where the economy is headed.

This is a plausible explanation of why stock prices change. But there is no hard evidence supporting it. It certainly has never been proven. It is a theory, that’s all.

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My view is that the evidence all points in a different direction.

Say that it were true that the market is forward -looking, that all that matters is investor assessments of what is likely to happen in the economy. If that were so, the P/E10 value would not predict future returns. How could it? P/E10 is not an economic indicator. If it were economic developments determining stock prices, the P/E10 value would be a meaningless number.

But there is hard evidence showing that P/E10 predicts future returns. This has been proven. So, if you are a person who is skeptical of theories that defy the available evidence, you should be skeptical of the claim that the market is forward -looking.

P/E10 measures the extent to which investor emotion is affecting stock prices. Any deviation from fair value pricing is irrational. So a high P/E10 value indicates a market heavily influenced by investor emotion.

Emotion is not forward-looking. People don’t say “I am thinking that I might lose my job five years from now, so I am filled with fear.” People become fearful when it becomes clear to them that the writing has been on the wall for some time that they might lose their job. Something breaks through their complacency and causes them to experience feelings that they have been pushing aside for some time. For so long as they remain emotional, their focus is on mistakes made in the past. Once they turn their attention to the future, they are becoming rational and thereby overcoming their emotions.

The stock market is generally backward-looking. We are not at high prices today because investors have formed an assessment that the economy is going to be doing well in coming years. We are at high prices today because we were at even higher prices a few years ago and most investors were not able to accept that the lower prices we saw in early 2009 as the new reality and took emotional comfort in a fantasy that those prices (fair -value prices) were an overreaction. We are able to rationalize today’s prices only because our emotions tell us that the insanely high pre-crash prices could not possibly have been as insane as they were revealed to be by the objectively determined P/E10 value.

We’re looking backwards, not forwards.

It was the same in 1982. Stocks were priced then to provide amazing returns on a going forward basis. That didn’t cause us to push the price up quickly. We were too focused on the poor returns of the 1970s to be able to turn our attention from the past to the future.

And it was the same in 2000. Stocks were priced then to provide horrible returns on a going forward basis. But we couldn’t shake our knowledge of how stocks had performed in the late 1990s. By looking backward, we were able to persuade ourselves that it made sense to own stocks at a time when they were selling at crazy prices.

Do investors ever look forward?

They must. There must be some forward-looking assessments being made or stock prices would never reflect fair value. And market prices do come to reflect fair value in the long term (that’s how P/E10 is able to predict the future — the long-term pull of stock prices is always in the direction of fair value).

The reality principle applies in the long term. High prices bring dividend payouts down. Dividends comprise two-thirds of the return paid by stocks. When dividends drop to low levels, returns over time drop to a low level too. This causes investors to become disgusted with stocks and to sell them. This causes prices to drop.

Market prices are self-correcting. But the price correction process is not something that takes place over a few days or a few weeks or a few months or even a few years. It can take 10 years for wildly overpriced stocks to return to something close to fair value or for wildly underpriced stocks to return to something close to fair value.

And look at how investors are thinking about stocks as that process plays out. Investors who become disgusted with stocks are not becoming disgusted about something they see happening to stocks up ahead in the future. The reality is quite to the contrary. By the time that most investors become sufficiently disgusted with stocks to sell, returns have been bad enough for long enough that going-forward returns are beginning to look better

Most investors are driving the car while looking in the rearview mirror.

Rob Bennett often writes about why short-term market timing never works and why long-term market timing always works. His bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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