Valuation-Informed Indexing #219
by Rob Bennett
In pre-Shiller days, those trying to understand stock investing suffered from confusion re the most fundamental points. University of Chicago Economics Professor Eugene Fama argued that the market was efficient, that all mispricings were quickly exploited for profit and thereby eliminated. But investors still kept track of valuations, an effort that makes no sense if stocks are always priced properly.
Yale Economics Professor Robert Shiller solved the puzzle by showing that all overvaluation and undervaluation is the product of investor emotion. The market strives to be efficient but can never achieve that goal until tools are developed that investors can use to adjust their stock allocations in response to big price swings with the aim of keeping their risk profiles roughly constant. We are not yet where we need to be because we still feel an emotional attachment to Buy-and-Hold strategies. But we intellectually know where we are headed — in the future the key goal of investors will be to stay the course not by keeping their stock allocations constant but to change their stock allocations as needed to keep their risk profiles constant.
Shiller changed our understanding of how stock investing works in a fundamental way. Each of the 219 entries to this weekly column are rooted in my belief that that is so. The purpose of this column is to explore the implications of Shiler’s “revolutionary” (his word — he uses this word in the subtitle of his book) finding that valuations affect long-term returns (which shows that the market is NOT automatically efficient, that it can become efficient only by investors becoming willing to change their stock allocations in response to big valuation shifts).
Lots of people do not yet appreciate all of the implications of Shiller’s work. The feedback that I have received on my 12 years of work developing the Valuation-Informed Indexing concept shows this to be so.
Incredibly, the signs are that Shiller himself does not fully appreciate many of the implications of his findings.
I say this because of the words I read in a recent interview with Shiller that I wrote about here two weeks ago. Shiller said that today’s P/E10 value “might be high relative to history but how do we know that history hasn’t changed?” Shiller believes that the long-term average for the valuation metric is “highly psychological.” He believes that “you can’t derive what it should be.”
If that really is so, then all of Shiller’s work (and all of my work too!) is pointless.
Shiller’s big insight is to show that long-term returns are predictable. To the extent that returns are predictable, risk is reduced. Shiller’s work has reduced risk dramatically. The peer-reviewed research that I co-authored with Wade Pfau shows that risk has been reduced by nearly 70 percent.
But only if we can say what the P/E10 value should be.
If Shiller is right in his recent comment that “you can’t derive what it should be,” his work is pointless. A high P/E10 value shows investors that they must lower their stock allocations. A low P/E10 value shows investors that they must increase their stock allocations. The P/E10 metric drives the Valuation-Informed Indexing strategy. If the proper P/E10 value cannot be known, there is no practical value to knowing that valuations affect long-term returns. If the proper P/E10 value cannot be known, there is nothing that can be done with Shiller’s findings to give them real-world value.
The fair-value P/E10 value is 15. U.S. Stocks have been providing a long-term average return of 6.5 percent real for 140 years now, as far back as we have records. Is it true that we cannot know that that will continue to be the case on a going-forward basis?
To a small degree that is indeed true.
It is possible that the long-term average return on a going-forward basis will be 7 percent. It is also possible that the long-term average return on a going forward basis will be 6 percent. The future may be different from the past in small ways.
But so what? That is of course true of ALL research-based findings. Becoming educated and working hard have been the keys to obtaining career success for a long time. It is of course possible and even likely that the types of education and the types of hard work that will pay off will be a bit different in the future than they have been in the past. But it would be a foolish career advisor who told young people that we really cannot know whether the factors that have always been key in the past will continue to be so in the future and that therefore we all might want to become slackers both a school and at work. Change is a constant in all sorts of life endeavors. But there are fundamental rules that will continue to apply as time goes by.
So it will be in stock investing.
We will learn new things as new research is produced. But the key factor in long-term stock investing success for 140 years now has been whether or not the investor took valuations into consideration when setting his stock allocation. The idea that that might not continue to be the case is the longest of all possible long-shots.
Does Shiller agree?
I certainly thought so until two weeks ago. I feel compelled to acknowledge that his recent comments raise doubts re this matter.
However, my guess is that Shiller is being overly humble re his huge accomplishments. Lots of people do not follow valuation-informed strategies. Many of those people are worried about where the market is headed (such worries are what will bring on the price crash that Shiller expects to see sometime over the next six months or so). Shiller is a kind man. I believe that he senses these worries, feels for the people experiencing them and is pulling back from strong statements re the merits of his investing model in his public comments about it as a result.
I don’t think this is a good idea. I think that people will be looking for explanations of what happened to their money following the next crash. Shiller is in the best position to offer reassuring words. His research will offer the best explanation of what happened, an explanation that will show us what we need to know to become far more effective investors in the future than we have ever been in the past.
But the message delivered by a deep understanding of Shiller’s research findings is a hard message for a lot of people to hear in today’s environment. And so Shiller is for the time-being understating the case.