Valuation-Informed Indexing #87
by Rob Bennett
Exclusive: York Capital to wind down European funds, spin out Asian funds
York Capital Management has decided to focus on longer-duration assets like private equity, private debt and collateralized loan obligations. The firm also plans to wind down its European hedge funds and spin out its Asian fund. Q3 2020 hedge fund letters, conferences and more York announces structural and operational changes York Chairman and CEO Jamie Read More
What is the fair-value P/E10 number?
Yale Economics Professor Robert Shiller, the grandfather of the Valuation-Informed Indexing model, puts it at 16. There’s a good case that can be made for that number. But “16” is not the only reasonable answer to the question “What is the fair-value P/E10 number?”
John Walter Russell, former owner of the www.Early-Retirement-Planning-Insights.com site, did the statistical work for development of The Stock-Return Predictor and the other calculators available at my web site. John put the fair-value P/E10 number at 14. He explained why in this article: Typical Values of P/E10.
John believed that the returns data from 1921 forward was more likely to reveal insights about how stocks perform in the modern era than was returns data from 1870 through 1920. He was not alone in this belief. Many researchers restrict themselves to data from more recent decades.
There’s another factor that adds a wrinkle. Stock prices follow a repeating pattern. Stocks gradually over time become overpriced and then remain overpriced for a good number of years. Then the price bubble is popped and stocks gradually over time become underpriced and then remain underpriced for a good number of years. Where we stand in this cycle at the time we are forming assessments of the fair-value P/E10 number influences what we discover through those assessments.
The mean P/E10 value from 1921 through 1985 (near the starting point for the huge bull) was 14.1. The median P/E10 value from 1921 through 1985 was 13.0.
Does it matter?
Not too much.
Even the most confirmed Valuation-Informed Indexer alive today (me!) would not claim that the tools that we have available to us today permit enough precision in the prediction of long-term returns for it to make a big difference whether the fair-value P/E10 number is 14 or 16. Perhaps in time it will come to matter more. As more people become Valuation-Informed Indexers, there will be more research done and we may get to a point where our tools are more refined and it will be possible to say whether “16” is the right number or “14” is the right number.
My purpose is presenting the case for John’s choice of 14 as the fair-value P/E10 figure is merely to show that it not yet settled that 16 is the precisely correct number. A good case can be made for 16. A good case can be made for 14. Since a good case can be made for 16 and for 14, a good case can obviously also be made for 15, the midpoint between the two.
The bottom line here is that we don’t know precisely what P/E10 value is the fair-value number. It may be that we are being influenced by the huge bull market. There was a fellow who posted under the screen-name “Schroeder” who used to tell me on discussion boards that the P/E10 value had been above 20 for so long that it was obviously never going to drop below 20 again. Schroeder stopped saying that when we for a brief time dropped to 13 in the early months of the financial crisis.
I hear a similar song from a number of my critics today. No one is willing to put forward emphatic statements today that we will never again drop below 20 (we are at 21 on the day I am writing this column entry). But a good number of Buy-and-Holders dismiss out of hand today my prediction that we will over the course of the next few years likely drop to 7 or 8 (we have ultimately gone to 7 or 8 in the wake of every earlier bull market in U.S. history).
When we have been at P/E10 levels in the 20s and 30s for so many years, people forget that it is super-high P/E10 levels that cause super-low P/E10 levels and that the odds of falling to 7 or 8 are greater when we are at those sorts of P/E10 levels than they are when we are at moderate P/E10 levels.
If we do go to 7 or 8 later in this decade, people won’t be citing “16” as the fair-value P/E10 number anymore. After another crash, the likelihood is that most people will be overreacting and saying that, just as in earlier days we could count on never seeing the P/E10 value drop below 20, we now can count on it never again rising above 10.
The truth is somewhere in the middle. Perhaps the fair-value P/E10 level is 16. Perhaps it is 14. Perhaps it is 15. What we know today is the rough truth that stocks are reasonably priced when the P/E10 value is somewhere in that neighborhood. A P/E10 value of 13 is not shockingly low. A P/E10 value of 17 isn’t shockingly high.
Fortunately, that’s all we need to know to become far more successful long-term investors than most of us have been at any earlier point in our investing lifetimes. Whether the fair-value P/E10 figure is 14 or 16, there is no reasonable case to be made for an investor failing to lower his or her stock allocation when the P/E10 value rises to the sorts of levels we saw it rise to in the late 1990s. That’s the big advance over Buy-and-Hold.
We should certainly engage in efforts to refine our tools as time goes by. But it would be a mistake to get too full of ourselves and start pretending that we know for certain that the fair-value P/E10 is one particular number and that there is no case to be made for using numbers in the same general neighborhood.
We know a good bit more than we knew in years past. But we don’t know it all or anything close to it as of today. The goal is to get it roughly right rather than to be caught falling into the trap of getting it precisely wrong.
Rob Bennett is a fan of the book Unexpected Returns. His bio is here.