Valuation-Informed Indexing #196
by Rob Bennett
Robert Shiller made a comment in his recent interview with PBS that showed how important it is that we never forget that his fellow Nobel Prize Winner Eugene Fama has also brought many powerful investing insights to the table.
Shiller was asked whether we are today again experiencing irrational exuberance in the stock market. He said: “Well, some people are. I have my own confidence indexes, which I’ve been computing for years now. It has bubble elements to it because people see the market going up and they’re regretting the fact that they didn’t buy in several years ago, and they are tempted back into it. But it isn’t the really strong bubble that we saw before because there are so many clouds — there are so many issues on people’s minds that it doesn’t look like the chance of a lifetime now. It can keep going up….It’s not a clear signal yet. Well, 25…. It could go up to 35, easily…. It’s time to be worried, but it’s not necessarily time to bail out.”
There’s good stuff in those words. I certainly share Shiller’s general take.
But I don’t at all like the manner in which the analysis is being performed. The way Shiller states things in those words is the way I often see Buy-and-Holders state things. There are too many weasel words and not enough actionable insight. He says: “It’s time to be worried. but it’s not necessarily time to bail out.” So investors are facing an elevated risk. And it might be time to bail out. He doesn’t say that it is NOT time to bail out, just that it might not be time to bail out. So Shiller’s covered if investors who find comfort in his words lose large portions of their life savings in the days ahead. Risk is elevated but it might not yet quite be the time to bail out. What actions should responsible investors take in response to these words?
I would state things differently. I would say: “I cannot tell you when the next crash is coming. Short-term timing doesn’t work. So I don’t even try to make short-term predictions. But I can tell you that there is almost certainly a price crash of about 65 percent coming in the next year or two or three. And being heavily invested in stocks when that crash comes will set you back many years, perhaps decades, in your retirement planning. You need to set your stock allocation with that reality in mind. Risk is sky-high when the P/E10 level hits the level it is at today. So please set your stock allocation where it should be at times of sky-high risk.”
Is that so hard? Why doesn’t everyone say it that way?
I think that it is because people are worried that if they say risk is sky-high when the P/E10 level is at 25 and then it rises to 35, as Shiller properly notes it might, they will be blamed by investors for being “wrong.” Reporting that stock-market risk is sky high today is right and not wrong and it doesn’t matter whether the P/E10 level rises to 35 or not. The risk is what it is. No amount of price rises can retroactively change the reality that risk is sky-high today. People need to know that and the experts in this field who fail to tell them this reality are not doing their jobs.
The problem on the part of the investors is that they have a short-term focus. They want to know how stocks are going to perform over the next year or so and that’s something that we just do not know. We shouldn’t fail to tell people how stocks are going to perform over the somewhat longer term just because we don’t know how they are going to perform over the next year or so. We should make the necessary distinctions and tell what we really can tell.
It’s true that the few advisors who state things that way put themselves in jeopardy of being called out as having been “wrong” since so many play the stupid parlor game of guessing what will happen over the next year or two. But that will never change until people like Shiller, who is the author of the “revolutionary” (his word) research showing that long-term predictions (unlike short-term ones) ALWAYS work, speak out in clear and firm and understandable words. I would like to see Shiller take a lead role in changing the rules of engagement so that better-informed predictions come to be voiced more frequently. We have to start somewhere.
The real killer, though, is when Shiller says that he is looking at “my own confidence indexes.” Fama would laugh at that statement. Fama would argue that any confidence indexes that one concocts are reflected in the price of stocks and thus impart no useful information. I think Fame is more right than Shiller on this one.
I obviously believe that Shiller is right on the broad issue. P/E10 predicts future stock prices. So Fama is wrong that all factors that can be examined are baked into the stock price. The valuations factor cannot be baked into the stock price. It is a logical impossibility for an indicator that tells us how mispriced stocks are at a given moment could be included in the price that applies at that moment. Fama believes in an absurdity.
But if P/E10 does its job, it serves no purpose to look at other indicators as well. All that that can do is to confuse the issue. P/E10 tells the story that we need to know. We should always look at P/E10 when setting our allocations. But we should leave it at that. Once we have incorporated the message being sent by the P/E10 value into our thinking, we should pay heed to Fama’s wisdom in arguing that we accept the (adjusted) market price as telling us what we need to know and that we put on blinders re other “indicators.” To fail to do so puts us on a course on which we go around and around in circles.
Shiller is trying to get things precisely right. He is turning to these other indicators in an effort to know not just when stock risk is sky-high but when the price crash is imminent. He is trying to win the short-term timing game! Isn’t that so?
As a result of Shiller’s amazing body of work, we now know how to make effective long-term predictions. We need to demonstrate to investors how big an advance we have achieved. We ill serve that aim when we try to push our prediction-making abilities too far.
P/E10 is a tool of immense power. No other indicators are of proven value or are needed. We should stick to what we know works and avoid the temptation to make use of additional tools to be able to do even more than that. Fama was right that stock predictions don’t generally work because the information used to make them are already incorporated into the market price. We need to keep that powerful insight in mind when making use of the one exception to the rule, the use of P/E10 to make long-term return predictions.