Valuation-Informed Indexing #150
by Rob Bennett
I recently engaged in a fascinating series of e-mail exchanges with Economics Professor Valeriy Zakamulin. We discussed every topic relating to investing theory under the sun. But I think it would be fair to say that all of our differences (there were many issues re which Valeriy and I are in agreement, to be sure) can fairly be summed up in a 17-word sentence that he offered in response to one of my claims.
“We cannot assume the existence of predictability just because there are no studies that fully reject it.”
So says Valeriy Zakamulin.
So believe most of today’s economic and investing experts.
I do not believe this. I believe precisely the opposite. The statement I would put forward is: “We cannot assume the existence of non-predictability just because there are no studies that fully reject it.”
There’s a lot riding on the matter of who is right re this one.
Like the continued viability of our free-market economic system.
Actually, I believe that that bold claim is an understatement of the full reality. If our economic system falls, confidence in our political system is going to plummet soon afterwards. We’ve already seen political tensions increase on both the right (via the Tea Party movement) and the left (via the Occupy Wall Street movement) as a result of the 2008 price crash. If valuations really do affect long-term returns, as the last 32 years of peer-reviewed academic research seems to show, we are likely going to see a much more devastating price crash in the not-too-distant future, one that will greatly exacerbate the political tensions that have come to the fore over the past four years or so.
So it is important that we get this one right.
Valeriy acknowledges that stock returns are to some extent predictable. However, he thinks that predictability is greatly limited. Thus, he doesn’t believe that our economy was sure to see a loss of $12 trillion in consumer buying power because the market was overpriced by $12 trillion in 2000. I do believe that. I believe that all overvaluation disappears after the passage of 10 years of time or so. Thus, we knew (if we cared to) in 2000 that sometime over the first decade of the 21st Century we would be experiencing at least the beginning of a massive financial collapse.
Valeriy (and lots and lots of other good and smart people) do not believe that the case is so clear. Valuations probably have an effect. But who knows how big that effect is? Except in cases where we are presented with undeniable proof that valuations should be taken into consideration, we should assume that predictability does not exist. That is, we should advise people that it is perfectly fine to follow Buy-and-Hold strategies, that no great harm is likely to come of it.
Why do we assume this?
My personal belief is that we can have a high degree of confidence that stock returns are predictable in the long run. I have looked at the historical data and I find the case compelling. My personal take is that we can say with 90 percent confidence that long-term stock prices are highly (but not perfectly) predictable. It’s possible to imagine us not seeing a loss of a full $12 trillion in buying power following the sort of overvaluation we experienced in the late 1990s. But it’s not possible to imagine not seeing losses at least approaching that figure. And of course losses anywhere even remotely in that neighborhood translate into an economic catastrophe. So, according to my way of thinking, we never should have permitted the heavy promotion of Buy-and-Hold strategies that permitted prices to rise so high in the first place.
But I am very much in the minority re this one. Even people who generally agree with me say that I express too much confidence in my viewpoints. There are more and more experts all the time who are willing to publicly acknowledge that long-term returns are somewhat predictable. Usually, though, they are reluctant to characterize Buy-and-Hold strategies as dangerous. Even most of those who believe that returns are somewhat predictable see it as perfectly reasonable to assume that returns are not predictable except in cases in which it is absolutely proven that they are are.
That default position makes it hard for Valuation-Informed Indexing to gain a footing. Few things in this world can be proven with 100 percent certainty and investing analysis is a new academic discipline. For so long as the default position is that returns are not predictable, Buy-and-Hold will be heavily promoted and will remain popular.
My question is — Why make that the default belief?
If we assume predictability in cases in which the evidence is not absolutely persuasive and it turns out that we were wrong to do so, it’s hard to see how much harm would come of the mistake. Investors who believe that returns are predicable will lower their stock allocations once prices rise to very high levels, thereby pulling them back to earth a bit. Is that such a terrible thing to see happen? It sure does not seem so to me. I view price stability as a good thing.
But consider what happens if it turns out that prices truly are highly predictable and yet we cling to an assumption that they are not. Prices will rise and rise and rise and rise until they reach the sorts of levels that applied in the late 1990s and then they will crash hard. The highest P/E10 level we ever experienced prior to the 1990s was the “33” that applied late in 1929 and that brought on the Great Depression. In 2000, the P/E10 rose to 44. In the event that our default belief turns out to have been wrong, the mistake is likely to cause a depression of far greater length and depth than the one we experienced in the 1930s and early 1940s.
I think we have as a society elected the wrong default position. If we are not sure whether long-term stock returns are predictable or not, we should be assuming that they are, not that they are not.
Rob Bennett has recorded a podcast titled What Your Money or Your Life Taught Me About Investing.” His bio is here. Valeriy