Valuation-Informed Indexing #197
by Rob Bennett
The research shows that we are not able to predict short-term price movements but that we are able to predict long-term price movements.
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It follows that we shouldn’t care about short-term bull and bear markets while we should care a great deal about secular (long-term) bull and bear markets.
You alway want to know whether we are currently in a secular bull or bear. Otherwise, you cannot make sense of anything that is going on.
But it just doesn’t make any difference whether we are experiencing a short-term bull or bear. A secular bear is going to swallow any gains made in a short-term bull and a secular bull is going to overcome the effect of a short-term bear. Paying attention to short-term price movements confuses and misleads.
When did the huge bull market that ended in January 2000 begin? The conventional wisdom is that it began in 1982. That’s when the Dow broke through the symbolically significant 1,000 mark and started heading upward in a steady and dramatic way. It’s an understandable way of looking at things. But I believe that the better-informed take is that the bull market began in 1975.
From 1975 through 1982 stocks offered a real return of 5.6 percent real. That’s a bit below the average long-term return of 6.5 percent real. But it’s a darn good return. Most investors would be happy to be invested in stocks during a time-period in which they were offering that sort of return. So why do so many think of those years as the end of a painful bear market rather than as the beginning of an exciting bull market?
It’s because we saw a significant price drop in 1981. The P/E10 level dropped from 9.3 to 7.4. Most people don’t view that sort of price drop as consistent with a bull market. It’s only when we got past that price drop that people feel prices starting going up persistently enough and dramatically enough to justify saying we were in a bull rather than a bear.
Here are the P/E10 levels that applied in January of each of the years from 1975 through 1983: (1) 9; (2) 11; (3) 11.4; (4) 9.2; (5) 9.3; (6) 8.8; (7) 9.3; (8) 7.4; (9) 8.8.
When the P/E10 level remains steady, the investor is earning the long-term average return of 6.5 percent real. So you don’t need to see increases in valuation levels to do well investing in stocks. Over those eight years, we did not see any significant drop in the P/E10 level. Yes, there was a drop from 1975 through 1982. But a drop that remains in place only a short amount of time should not even by noted by a long-term investor. The temporary drop to 7.4 that we saw in 1982 just didn’t amount to anything of long-term consequence. It’s the long-term that matters. It’s the long-term to which we all should be paying attention.
This is a big deal.
Say that you were debating what sort of stock allocation to go with in 1975. A P/E10 level of 9 signifies that stocks offer a very strong long-term value proposition. If you hold the opinion that the bull market did not arrive until 1982, you are likely thinking that going with a high stock allocation in 1975 did not start paying off for seven years. The reality is that it started paying off immediately. The price jumps were not as dramatic in the pre-1982 years as they were in the post-1982 years. But steady non-dramatic gains are a big plus. You certainly wouldn’t want to have missed out on stocks during those years. So why characterize the years from 1975 through 1982 as bear years, a characterization that suggests that those were bad years to be invested in stocks?
Shiller’s finding that long-term timing always works, combined with Fama’s finding that short-term timing never works, should change how we think about stock investing in a fundamental way. Our natural inclination is to focus on the short-term. We live in the short term and we possess a natural skepticism about efforts to predict long-term results. But the research is showing us that the short term just doesn’t matter, that the predictable long term always dominates in the end. So we need to make an effort to shift our focus.
We are living through the opposite of the 1975-1982 experience today. Many investors have concluded that we are in a bull market because prices have been headed upward for several years. No. There has never been a secular bear market that ended without us touching a P/E10 level of 8 and remaining in that general neighborhood for a number of years. In this secular bear, we haven’t yet gone anywhere near 8 and we were at fair-value price levels for only a few months in early 2009. Today’s bull market gains are a temporary phenomena that will be washed away into insignificance by the power of the long-term bear in which this short-term bull has asserted itself.
It’s when we have experienced the next crash that we will be at the price levels at which real bulls, secular bulls, are born. Don’t be fooled if we spend several years with the P/E10 value well below fair-value levels. It doesn’t matter. So long as the P/E10 value remains stable, stocks offer a strong long-term value proposition. You always want to be thinking about where prices are headed. When prices are at rock-bottom lows, there’s only one direction in which they can be headed!
I don’t think it would be exaggerating too much to say that the secret of successful stock investing is tuning out the short-term noise and focusing on the long-term realities. It sounds easy but there is something about refusing to call a time in which prices have been rising for several years running a bull market that strikes most of us as a highly counter-intuitive way to think about things.
Rob Bennett has recorded a podcast titled Jeremy Grantham Tells the Truth (Straight, No Chaser) About Stock Investing. His bio is here.