Valuation-Informed Indexing #43: The Most Important Number in Stock Investing

reminiscences of a stock operator pdf

by Rob Bennett

Study stock investing and you are exposed to a lot of numbers. It’s numbers, numbers, numbers, everywhere you look!

Most of them don’t mean too much. Many of them are employed to support rationalizations that end up doing you a lot of harm.

But some numbers matter. I learned about one the other day that in my view tells a story more important than any story told by any other number I have come across in my explorations of what works in stock investing.

The number comes from a new study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo, Japan, that offers a number of powerful insights.

We’ve all of course heard for years about all the studies that show that short-term timing doesn’t work. But what about long-term timing (changing your stock allocation in response to big price swings with an understanding that you may not see benefits for doing so for as long as 10 years)? Surely long-term timing works. Long-term timing is just taking price into consideration when buying stocks. How could that possibly not work?

Pfau went looking for studies on this point and was surprised to find only one, a study that its authors suggested lent support to the proposition that long-term timing doesn’t work. Pfau ran the numbers. His study is titled Revisiting the Fisher and Statman Study on Market Timing.

He of course found that long-term timing always works. The new study states: “On a risk- adjusted basis, market-timing strategies provide comparable returns as a 100 percent stocks buy- and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.”

Pfau charts the nominal wealth accumulation of $1 invested at the start of 1871. The Buy-and-Hold strategy examined is one in which the portfolio was comprised 100 percent of the S&P 500 index. The market timing strategy is one in which a choice is made to go with either 100 percent stocks or 100 percent Treasury bills at the start of each year, depending on whether the value of P/E10 is below or above it’s historical average at that time.

The Buy-and-Hold portfolio was worth $95,404 at the end of 139 years. The Valuation-Informed Indexing portfolio was worth $124,147.

Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”

That maximum drawdown number is now my favorite numerical way of illustrating the secret to successful stock investing. Many experts define risk as volatility. But volatility is often not that big a deal. Moderate volatility, volatility not strong enough to cause you to sell your stocks, will not hurt you in the long run. But volatility that scares you enough to cause you to sell stocks when prices are down can set back your retirement dreams by many years.

So the best way to diminish the risk of stock investing is to invest in such a way that your maximum drawdown number is low. If your worst-case scenario is not that bad, you are never going to feel compelled to sell when prices are low and in the long run you will do fine. Being willing to abandon Buy-and-Hold for Valuation-Informed Indexing in one moment lowers your maximum drawdown from 61 percent to 24 percent. That is no small improvement!

The biggest mistake that stock investors make is thinking that stocks are equally risky at all times. Stocks are a virtually risk-free asset class at times of low valuations and carry only modest risk at times of moderate prices. It’s at times of super-high prices (like those we have been living through from 1996 forward) that stocks are super-risky, so risky that it is a rare middle-class investor who is able to overcome the pressures to sell that follow from the multiple crashes that always come at such times. Times of super-high prices comprise probably no more than 30 percent of an investor’s lifetime. Keep your stock allocation low at those times and you dramatically diminish the risk of this asset class for you.

Noting that the Valuation-Informed Indexing portfolio is able to generate the same returns as the Buy-and-Hold portfolio while being out of stocks half of the time and thus putting itself at what should be a huge disadvantage according to Modern Portfolio Theory, Pfau also compares the Valuation-Informed Indexing portfolio, which has an average stock allocation of 50 percent, with a 50 percent Buy-and-Hold portfolio.

In this case, the risks of the two portfolios are roughly equal but the returns for the Valuation-Informed Indexing portfolio are dramatically superior. The Buy-and-Hold portfolio has an end-point (2010) value of $13,426. The Valuation-Informed Indexing portfolio has an end-point value of $94,866.

The study concludes: “Valuation-based market timing with PE10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

You don’t say!

Rob Bennett has written a case study in financial life planning. His bio is here.

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12 Comments on "Valuation-Informed Indexing #43: The Most Important Number in Stock Investing"

  1. First let me say you’re the politest guy on the internet, such a soft touch!
    What a kind thing to say!

    You’ve brought a nice measure of good cheer to my Wednesday afternoon, Jonathan. It makes me so happy to hear that someone thinks that.

    Please stop back anytime!

    Rob

  2. First let me say you’re the politest guy on the internet, such a soft touch!

    “His study shows that VII works even when you go with TBills. But TBills are a horrible asset class.”

    Well, I would say that it worked with TBills because TBills haven’t been a horrible asset class very often – but they are right now.

    As for the rest I agree. I’m entirely on board with valuation based investing, I was just pointing out that this guys strategy wouldn’t likely work for the next handful of years. 

    [Details: For TIPS the tax treatment (for individual investors) is horrible – real cash tax payments on imputed earning. IBonds are possible, although again at current rates of 0% fixed and 2.3% “inflation” I can see many points where you’d still lose (I’m applying this against S&P for last 70 years through a matlab script).]

    I’m actually doing something similar to the paper with my money, just had a heck of a time figuring out where I could store the money and make some safe interest.

    Thanks for all the posts and tweets, keep it up!

     -Jon

  3. Are there any websites that monitor P/E10 values of various indexes/ETFs (both Canadian and US) so that one can time the rebalancing of allocation to bonds and stocks?
    No. But there should be!

    To make sense of any of this, you have to understand the history. Buy-and-Hold represented a huge intellectual advance. We learned many very important things from the Buy-and-Holders. I find fault with them for their mistakes all the time, so I think that it is important that in fairness I make an effort from time to time to point out all the good the Buy-and-Holders have done. Buy-and-Hold is the first model for understanding how stock investing works that is rooted in a systematic study of the research and data. That’s a big deal.

    The Buy-and-Holders obviously could not know everything that was ever going to be known about stock investing at the time they put forward their ideas. People didn’t stop doing research in 1976, when Bogle founded Vanguard. Shiller did not show that valuations affect long-term returns until 1981. The reason why the Buy-and-Holders did not include an adjustment for valuations in their studies is that we didn’t know at the time that it was required; we did not learn how important valuations are until a few years after the industry started promoting Buy-and-Hold.

    The trouble is that, once they started pushing Buy-and-Hold so hard, they did not want to acknowledge that they had made mistakes. So they have continued pushing Buy-and-Hold for 30 years after Shiller showed that it can never work for the long-term investor. That’s why we are in an economic crisis today.

    We are today in a strange twilight zone. We know what works to a far greater extent than any people who ever came before us. If you combine the Buy-and-Hold insights with the Shiller insights, you have the world’s best investing strategy (Valuation-Informed Indexing). It’s a low-risk/high-return approach. There’s only one problem — We must not tell anyone about it! If we do tell, it makes the Buy-and-Holders feel funny because they have been doing it wrong for so many years now. Oh, my!

    As the economic crisis worsens, we are going to see more and more pressure imposed on the “experts” in this field to come to terms with Shiller’s finding (that is, to abandon Buy-and-Hold and move to Valuation-Informed Indexing). When that happens, you will be seeing every web site on the internet providing the type of information you are making reference to here. They don’t do it today because there is a social stigma attached to pointing out the dangers of Buy-and-Hold. But that cannot last. The new (30 years old but shockingly new to most of us!) findings are too important to keep bottled up forever.

    Until that happens, please understand that there is no need to make frequent allocation shifts. You don’t need to check the P/E10 for stocks more than once per year. You don’t have to get things precisely right for VII to help you retire many years sooner. You just need to avoid major allocation mistakes. You don’t want to be heavily invested in stocks when prices are insanely high and you don’t want to be out of stocks when prices are insanely low. If you avoid those two mistakes, you will end up ahead of the vast majority of investors. Most today think that it is okay to stay at the same stock allocation at all times (to rebalance).

    I wish you the best of luck with whatever strategies you elect to follow!

    Rob

  4. By the time the P/E comes down inflation has made you poorer if you didn’t have a fair return on T-bills. I bring this up because right now you can’t get any real return on your T-bills.
    You’re bringing up a super point, Jonathan. Thanks.

    Why go with T-Bills?

    The reason why Valuation-Informed Indexing always works is that it is logically impossible that it would ever not work. All you are doing is comparing the real return you would get from a risky asset class with the real return you would get from a non-risky asset class and avoiding the risky one when the real return is higher than it is with the non-risly one. How can it not work to obtain a higher return from a less risky asset class?

    I don’t see why you would consider TBills. Go with IBonds or TIPS. They are inflation-protected asset classes. That way you are covered.

    I understand that Wade used T-Bills in his study. That’s standard practice in these investing studies. I engaged in e-mail correspondence with him in which I urged him to look at non-stock asset classes other than T-Bills (TIPS or IBonds). His study shows that VII works even when you go with TBills. But TBills are a horrible asset class. If this works with TBills, how could it not work with far superior asset classes?

    At times when stocks are likely to provide a better return than TIPS and IBonds, you should be in stocks. I certainly don’t say different. But why go with stocks when your compensation for taking on all that extra risk is to obtain a lower return? This is the thing I don’t get. That one really makes no sense to me.

    Anyway, you have put forward a super point that may convince some people that this VII idea is not as hot as I claim it to be. That’s a good thing. I am an effusive person and it is good to have people like you making strong, rational counter-arguments. You have added some much needed balance to the discussion and I am grateful to you for taking the time out of your say to help us all out.

    Rob

  5. The key thing to watch for here is the same thing mentioned in Valuation-Informed Indexing #42, ironically enough – the results depend on your starting point.

    If you dig through the paper for Figure III you’ll see that the approach published misses most of the gains of the 60s and is out of the market from 1989 to 2009. In both cases if you look at the NOMINAL values of the S&P 500 you would never get a chance to enter the market at anywhere near those values again. By the time the P/E comes down inflation has made you poorer if you didn’t have a fair return on T-bills.

    I bring this up because right now you can’t get any real return on your T-bills so the strategy doesn’t seem to apply for as long as the fed keep rates artificially low (which Bill Gross et al predict will happen for a very long time).

    Take a look at Figure 3 and imagine if the top plot flattened out when the bottom plot says get out of stocks – you’ll quickly see that it doesn’t work any more.

  6. Thanks Rob.

    I am in Toronto, Canada; and 56 years old.  My savings in retirement and non-retirement accounts are mostly in mutual funds — about 60% in equity mutual funds and the balance in bond mutual funds.  After finding out about the benefits of ETFs I have started the process of switching over and am not sure if the Canadian equity-based ETFs are overvalued at this time.  If S&P 500 index is overvalued then I am pretty sure the Cdn stock market is overvalued too.  From what I gather from your reply, I will be better off investing mostly (80%?) in a real-return (inflation-adjusted) bond ETF at this time; and change the balance in future when the stocks are more reasonably valued (P/E10 in the range of 8-14?).

    Are there any websites that monitor P/E10 values of various indexes/ETFs (both Canadian and US) so that one can time the rebalancing of allocation to bonds and stocks?  I checked out the multpl.com site which seems to be dedicated to S&P 500 index only.

    I have always felt uneasy using my age to determine the bond vs equity split (age= 55, therefore 55% in bonds and 45% in stocks). Just feels too arbitrary!

    Warm regards,

  7. churning every year or two 
    Thanks much for stopping by, Rmorris.

    There’s no need to “churn every year or two” to invest effectively in stocks. This idea is promoted by The Stock-Selling Industry as a means of scaring us into thinking that we need to be heavily invested in stocks even at times when they are selling at insanely dangerous prices.

    Stocks were either low-priced or moderately priced for the entire time-period from 1975 through 1995. Stocks were insanely overpriced from 1996 through today (with the exception of a few months in early 2009). So there was only one allocation change you needed to make in 35 years! The transaction costs you incur with one allocation change in 35 years are minimal.

    But that one allocation change would increase your portfolio size enough to permit you to retire five years or 10 years sooner. Why? Because there has never once in history been a time when stocks provided a poor long-term return when purchased at the sorts of prices that applied from 1975 through 1995. And there has never once in history been a time when stocks provided a good long-term return when purchased at the sorts of prices that applied from 1996 through 2011. 

    Stocks are like everything else that can be purchased with money. There are some prices at which they provide a great value proposition and there are some prices at which they provide a horrible value proposition. Any claims to the contrary are rooted in marketing considerations rather than in an objective assessment of the historical stock-return data and the academic research examining this question.

    That’s my sincere take on the matter, in any event. I could be wrong. And there are many good and smart people who very strongly believe that I am!

    Rob

  8. The difficult part is how does the average punter tell when the price is low, moderate, or high price ?
    Thanks for stopping by, Jim. 
    This is why I built The Stock-Return Predictor:
    http://www.passionsaving.com/stock-valuation.html
    The Predictor tells you the likely long-term return for stocks starting from any P/E10 level. Just compare the return you will get from stocks to the return available from the super-safe asset classes and you know where to set your stock allocation.
    The only reason you don’t hear about this at every investing site you go to is that most investing “experts” have ties to The Stock-Selling Industry. Expecting investing experts to give you the straight story on stocks is like expecting a used-car salesman to give you the straight story on how much the car he is trying to push is really worth.
     For accurate and balanced information, you need to go to sources that are more independent. I have hopes that in days to come we will see many internet sites offering honest and balanced and realistic and accurate information on stock investing.
    Rob

  9. Thanks for stopping by, Be’en.

    The P/E10 for the S&P 500 is reported here:

    http://www.multpl.com/

    That link tells us that the current P/E10 value is 23. To find out what that means re future returns, we go to The Stock-Return Predictor:

    http://www.passionsaving.com/stock-valuation.html

    The Predictor tells us that the most likely annualized 10-year return for an index-fund purchase made when the P/E10 is 23 is 2 percent real.

    I believe that I should be compensated for taking on the risks of stocks by at least 2 percentage points of return over what I can obtain from a super-safe asset class like IBonds or CDs. You can get 1 percent real today from the super safe asset classes. So I don’t see stocks as appealing at today’s prices.

    Many worry that a return of 1 percent real is not good enough. I view this as a misplaced concern. The P/E10 level has fallen to 8 in the wake of every major bull market we have seen in history (the only thing that can end a bull is a crash and a crash always causes an economic crisis because it causes so much wealth destruction). When we get to 8, the likely annualized 10-year return is 15.

    The money you invest today will only be earning 1 percent real for a few years. Then it will be earning something in the neighborhood of 15 percent real for 10 years running. The long-term return on that money will not be 1 percent but something a lot closer to 15 percent than 1 percent.

    Rob

  10. Does this include tax effects?  Deferring the tax payment is a massive benefit over an extended period vs churning every year or two and having to pay the gains

  11. Rob

    Are P/E10 values for various ETFs on market available somewhere to determine which ones are a good buy at a given time?  If equity ETFs are overvalued at this time, should one go in to debt ETFs or invest in term deposits only?

  12. ‘Stocks are a virtually risk-free asset class at times of low valuations and carry only modest risk at times of moderate prices.’
    The difficult part is how does the average punter tell when the price is low, moderate, or high price ?

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