Valuation-Informed Indexing #207
by Rob Bennett
A regular contributor to my blog posted the following words to the comments section of one of my blog entries the other day: “Why do you think Treasury bonds have a lower yield than Spanish bonds?” I often argue that the conventional wisdom that stocks pay high returns because they carry more risk than most other asset classes and that investors demand compensation in the form of higher returns in exchange for taking on that risk. A regression analysis using P/E10 values shows that the most likely ten-year annualized return in 2000 (when prices were the highest they have ever been in history) was a negative 1 percent real while the most likely ten-year annualized return in 1982 (when prices were very low) was 15 percent real. Stocks were far more risky in 2000 than they were in 1982. But the likely return in 1982 was far greater. Investors did not demand higher returns when risk was high, they were perfectly happy to accept far lower returns.
David Einhorn's Greenlight Capital returned -2.9% in the second quarter of 2021 compared to 8.5% for the S&P 500. According to a copy of the fund's letter, which ValueWalk has reviewed, longs contributed 5.2% in the quarter while short positions detracted 4.6%. Q2 2021 hedge fund letters, conferences and more Macro positions detracted 3.3% from Read More
The point about the Spanish bonds is well-taken. There is evidence of rationality in the markets. My response is that there is also evidence of irrationality. Rational and irrational investing ideas co-exist.
People have a hard time with this.
I have co-published research in a peer-reviewed journal showing investors how to reduce stock investing risk by 70 percent (the trick is to adjust your stock allocation in response to big valuation shifts). In ordinary circumstances, you would expect that this paper would have been written up at every investing site on the internet. Who doesn’t want to know how to reduce investing risk by 70 percent? Who doesn’t want to be able to tell his or her readers how to do this? You would be surprised.
People don’t respond with excitement when they learn that it is possible to reduce stock investing risk by 70 percent. They respond with worry. What if it doesn’t work? It’s been working for 140 years. What if you got something wrong? The paper passed peer-review and is subject to challenge to anyone who has access to the internet. What if it stops working? Anything can happen in this crazy, mixed-up world of ours but most of us elect to get out of bed every morning and brush our teeth and get on with the business of the scary new day all the same.
There’s something about stock investing that makes people think it should be rational. There’s money involved. I think that’s the thing. Bankers don’t wear loud ties because folks who appreciate formality in every other life endeavor sleep better knowing that their retirement money is being handled by people of great prudence. We don’t want the people handling our money to be wild and crazy guys and gals. So we like to think that there is some magical force rendering the stock market a rational place.
It’s not so.
The market is every bit as rational and every bit as nutso as the humans who participate in it. That’s us! The market is no more serious or silly than all of us who have money in it.
Spanish bonds are riskier than U.S. bonds. That one is easy. So we get that one right.
The insane riskiness of stocks when the P/E10 value that applied in 2000 evidences itself is not so easy to detect. Stock prices skyrocketed from 1996 through 1999. One of our human failings is to place undue emphasis on recent developments while improperly underweighting long-applicable historical realities. So we went collectively bonkers re the stock investing question in 2000.
We are capable of rationality. But we are also capable of abandoning rationality. The best thing to do is to encourage each other to be rational. That would push the odds a bit in our favor. Unfortunately, another one of our human failings is to want to shoot messengers telling us that our portfolios are worth only one-third of what the people trying to sell us stocks say they are worth (stocks were priced at three times fair value in 2000). So we have an inclination to put a lot more energy into rationalizing bull-market prices than we put into helping each other appreciate the lessons of the academic research of the past 33 years.
Come to think of it, it is possible that we are not being entirely rational in our thinking re Spanish bonds. U.S. bonds should cost more. We got that one right. But can we really say for sure that the spread between the prices of the two types of bonds is today set properly? I don’t think so. It seems to me that it is entirely possible that we today exaggerate the extent to which U.S. bonds are safer because they have been safer for so long a time.
Or perhaps its the other way around. Perhaps we don’t fully appreciate how much safer U.S. bonds are. Since I am one of the irrational humans, I cannot say! Or, if I do say, it’s important that you understand that, despite my efforts to steer you right, I may be steering you very wrong. The annoying thing about irrationality is that those evidencing it are the last to know that they are doing so.
I’m not saying we should throw out hands up.
What I believe is that we should place more emphasis on what the historical return data tells us. The return data is not subject to the flawed humanity that mixes irrationality with rationality to create lethal investing concoctions.
The Alfred Hitchcock twist is that this is just what the Buy-and-Holders thought they were doing. The Buy-and-Holders dogmatically refuse to take Shiller’s findings into consideration because they turned to the historical data for escape from the subjectivity of earlier forms of investing analysis and vowed never to permit themselves to be talked out of the conclusions they reached by doing so. Even when the talking was being done by 33 years of academic research showing that their initial findings pointed in the opposite direction of what really works.
The partly rational/partly irrational humans will get it right one of these days.
Rob Bennett has recorded a podcast titled Cash on the Sidelines Sometimes Disappears Into Nothingness. His bio is here.