The Yearly Review Illusion: Short-Term Ups and Down Have Little Effect on Long-Term Results


Valuation-Informed Indexing #184

by Rob Bennett

I’ve been predicting a price crash of about 65 percent for a long time now. A reader of my blog recently asked me why the size of the crash that I see coming did not change even though stocks enjoyed a big return in 2013.

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It’s a good question. Intuitively, you would think that a year of good returns would set stocks up for even a bigger crash. However, when you look at the  numbers you see that even dramatic single-year results rarely do much to change the long-term picture.

The idea behind the 65-percent price-crash prediction is that every secular bear in U.S. history has ended when we got to a P/E10 level of 7 or 8. Today’s P/E10 level is 26. A drop to 8 would translate into a price drop of a little more than 65 percent.

We’ve seen a lot of price growth over the past two year. Still, the full reality is that the P/E10 value was 21 in January 2012. A drop from 21 to 7 is still a  price drop of 65 percent.

Am I being unfair in assuming a price drop to 8 in the one calculation and a price drop to 7 in the other? I don’t think so. We don’t know whether the price drop is going to be to 8 or to 7. So it seems to me that it is fair to use either number. And the difference between a drop to 8 or 7 is not great in any event.

Perhaps the precisely correct way of saying things would be to say that we were likely to see a price drop of a bit less than 65 percent in 2012 and that we are likely to see a price drop of a bit more than 65 percent today. But isn’t that a silly distinction? A price drop of 60 percent will be a terrifying event. And a price drop of 70 percent will be a terrifying event. The bottom line here is that a price drop of anything even remotely in the neighborhood of 65 percent will be a terrifying event. And the price rise we have seen over the past two years is not anything close to what we would need to see to change the realities in a meaningful way.

The point being made here has far-reaching implications.

One of the complaints I often hear from people who are skeptical of Valuation-Informed Indexing is that they don’t want to incur the expense of making lots of allocation changes. That’s a non-issue. It is possible to engage in Valuation-Informed Indexing effectively without changing your stock allocation more than once every ten years or so. Frequent changes simply are not necessary.

Consider recent history. Stock prices were low in 1975 and then did not become insanely high until 1996. So an investor could have remained at a high stock allocation for that entire 22-year time-period without too much concern of suffering the bad results that follow from being over-invested in stocks. With the exception of a few months in early 2009, we have been at high or super-high prices for the entire time-period from 1996 through early 2014.  So, again, there has been no need for an allocation adjustment for 18 years running. If you adopted a high stock allocation in 1975, switched to a low stock allocation in 1996, and stuck with that low stock allocation until today, you made one change in your stock allocation in 39 years and yet invested in a manner entirely in accord with what the last 32 years of peer-reviewed academic research shows is proper.

That’s weird, isn’t it?

I think it is yet another reason for rejecting the core Buy-and-Hold idea that the market is efficient. An efficient market would not remain either overvalued or undervalued for such long time-periods. It would jump from one state to another with more frequency. To understand why markets remain either overvalued or undervalued for so long, we have to take into consideration the role played by investor emotions and that of course means leaving behind us the possibility that the Efficient Market Theory is valid.

It’s exciting news that stocks remain overvalued or undervalued for long periods of time. It means that you don’t have to worry about missing out on gains or losses because you are slow to make moves. The best thing was to go with a high stock allocation in 1975. But if you missed that bus, another one came along in 1976 and then another in 1977 and then another in 1978 and on and on and on. It worked the same way when the long-term value proposition was headed in the other direction. You wanted to lower your stock allocation in 1996. But 1997 was another good year for doing so. And 1998 was yet another. And 1999 was yet another. And so on and so on and so on.

Stock market realities generally remain roughly constant for long periods of time. Stocks were a bad bet in 2012. They remain a bad bet today. We saw gains in 2012 and in 2013. However, in the long term, they amount to almost nothing. If you made the right call (a low stock allocation!) in 2012 and 2013, you are almost certainly going to do well in the long term even though there was some noise in the media suggesting otherwise during those years.

One of the many things that baffles me about Buy-and-Holders is how they claim that they follow a long-term strategy yet they are forever citing their short-term results. Valuation-Informed Indexing is the strategy that walks the long-term investing walk as well as talks the long-term investing talk. For those of us who take valuations into consideration when setting our stock allocations, the short-term becomes immaterial. Either the price at which stocks are selling justifies a buy or it doesn’t. The little blips up and down that so consume the media are a distraction from the stuff that matters.

Bennett has recorded a podcast titled Stock Cycles. 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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