Valuation-Informed Indexing #232
by Rob Bennett
Last week’s column examined the last 19 years of stock returns. We saw that the core principle of Buy-and-Hold, that stocks are always the best asset class for the long term, was vindicated for those who bought in 1996, as stocks have performed well from that point forward even though they were insanely overpriced when the purchase was made. However, we also saw that the core principle of Valuation-Informed Indexing, that investors who ignore valuations always live to regret it in the long-term, was vindicated for those who bought in 2000, as super-safe asset classes like Treasury Inflation-Protected Securities and IBonds have delivered far higher risk-adjusted returns from 2000 forward.
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It all comes down to that four-year time-period from the beginning of 1996 through the end of 1999. Buy-and-Hold and Valuation-Informed Indexing performed the same from 1981, when Shiller published his “revolutionary” (his word) research, through the end of 1995 because both strategies call for high stock allocations when prices are low or moderate. Valuation-Informed Indexing has soundly defeated Buy-and-Hold for the past 15 years. But most investors continue to maintain confidence in Buy-and-Hold because the gains experienced during the last four years of the last Century were great enough to make the less-than-satisfying returns experienced in the 15 following years seem not so bad given the total investing experience from 1981 forward.
Those four years truly did deliver amazing results for Buy-and-Holders. Investors who were persuaded by Shiller’s research to lower their stock allocations in January 1996 would have missed out on a return of 24 percent real in 1996, 26 percent real in 1997, 29 percent real in 1998 and 12 percent real in 1999. The overall return for the four-year time period was 127 percent real. I went to a zero stock allocation in 1996. Yikes!
The question remains, however, whether I or any of the other investors who permitted Shiller’s research to guide their allocation choices “missed out” on anything at all in a permanent sense. Shiller’s research shows that all gains beyond the 6.5 percent real that is the result of economic growth are the product of investor emotion, temporary cotton-candy gains that will disappear as the short-term turns into the long-term.
Most investors believe that the poor gains we have seen for the past 15 years are the price we had to pay for letting the market become overvalued but that stocks should be a solid asset class on a going-forward basis. But the reality is that the P/E10 value is today higher than it was in January 1996, when prices reached scary high levels. We are now at price levels not at which secular bear markets come to an end but at which they begin. If stocks continue to perform in the future anything at all as they always have in the past, the biggest crash is not in the past but in the future.
We need to understand what happened in those crazy four years.
The Buy-and-Hold Model posits that price changes are determined by economic developments. Stock prices more than doubled from 1996 through 1999. Did the real economic values of the underlying companies double in value?
The Valuation-Informed Indexing Model posits that price changes are determined by investor emotion. Don’t the numbers quoted above support this view?
Prices should never double over the course of four years. Buy-and-Holders cheer when this happens because they are happy to believe that they are closer to well-financed retirements. They shouldn’t cheer. When prices rise that far that quickly, the message being delivered is that their model for understanding how stock investing works is gravely flawed. Fantastic numbers should frighten investors, not reassure them.
Of course, losses will not take place until large numbers of investors come to believe that they are inevitable. So long as investors believe in Buy-and-Hold, it continues to work. But how long can investor confidence be maintained in the face of the returns we have seen since January 2000? TIPS have sounded defeated stocks for 15 years running now (the return for TIPS purchased in 2000 has been 4 percent real while the return for stocks has been 2 percent real). That’s not supposed to happen! The Buy-and-Hold Model posits that investors should be compensated for taking on extra risk. Stocks are a far more risky asset class than TIPS. Yet TIPS have been providing double the return for 15 years running!
The correlation between valuations and long-term returns is strong. This has been known for 33 years now. Most investors rationalize away the correlation by arguing that something has changed in the way the market works that will cause the correlation to weaken in the future. But the strong correlation between today’s P/E10 level and the long-term stock return is far from the only evidence in the historical data that throws doubt on the Buy-and-Hold Model.
Those four years of crazy returns did not appear out of nowhere. They took place at the top of a bull market that had been growing for two decades. They took place at the threshold of a bear market that has continued for 15 years since. It is not just the correlation between valuations and long-term returns that shows that the market is not efficient. The patterns in which returns have been falling for 140 years now highlight the point.
The 126 percent return we saw over those four years was the product of investor emotion. All signs point to this conclusion. There is no rational reason why so much economic growth would be squeezed into such a short time-period. The fact that so many investors rationalize away the case against their favored strategy is just more evidence that Shiller is right, that it is emotion that carries the day in the setting of stock prices. There is nothing more emotional than an investor who denies the presence of emotion in the setting of stock prices!
There was nothing “efficient” about what happened in those four years. What happened in those four years is that investors let their emotions overwhelm their common sense. We are only in the early years of paying back the debt we incurred. The hope is that this is the last time we will experience four years of such craziness because following the next crash we will all see the need to take Shiller’s revolutionary findings more seriously than we have taken them up until now.
Rob Bennett recorded a podcast titled 2008 Was a Very Good Year for Stock Investors — Let’s Hope that 2009 Is Not a Repeat! His bio is here.