Valuation-Informed Indexing #231
by Rob Bennett
Stock prices reached dangerously high levels in 1996. That’s when I got out of stocks because of my belief that valuations affect long-term returns and that the super-safe asset classes like certificates of deposit (CDs), Treasury Inflation-Protected Securities (TIPS) and IBonds offered a stronger long-term value proposition. After the passage of 19 years, you would think that we would have a crystal-clear real-world demonstration re whether that was the right call of not.
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
We do not.
From one way of looking at things, Buy-and-Hold has performed very well over those 19 years, From another way of looking at things, Valuation-Informed Indexing has offerer superior results. I’ll present the numbers and leave it to you to determine which model for understanding how stock investing works does the better job of explaining what is going on in the real world.
The super-safe asset classes have offered a return of 4 percent real for those 19 years. Few investors obtain that return from their non-stock investments, to be sure. But those who believe that the 34 years of peer-reviewed research showing that investors must change their stock allocations in response to big valuation shifts to have any realistic hope of long-term investing success were looking for an alternative to stocks as soon as the P/E10 level crossed the “25” threshold in the mid-1990s. CDs were at that time offering a real return of 4 percent real or more. And TIPS and IBonds permitting investors to lock in that 4 percent real return for up to 30 years became available a few years later (because stocks were so insanely popular and the only way to entice stock-addicted investors to purchase these new asset classes was to offer insanely high returns for super-safe asset classes).
Stocks are more risky than TIPS or IBonds. The rule-of-thumb that I use is that stocks should offer a return 2 full percentage points higher than the super-safe asset classes to justify the added risk that goes with owning them. So to my way of thinking stocks needed to offer a return of 6 percent real or greater over those 19 years to justify an investment in them. Of course some Buy-and-Holders might be satisfied with any return that beat the return offered by CDs, TIPS and IBonds. For those investors, stocks had to offer a return in excess of 4 percent real to be worth owning during this stretch of time.
Did stocks offer a return of between 4 percent real and 6 percent real over this 19-year time-period?
The real return (with dividends reinvested) for the S&P 500 over that time-period was 6 percent real.
That’s very close to the average long-term return for stocks over the 140 years for which records are available — 6.5 percent real. A return that high for that long a time-period suggests that the Buy-and-Holders are right to ignore valuations when setting their stock allocations.
A regression analysis of the historical return data shows that the most likely 20-year annualized return for a stock purchase made at the price that applied in January 1996 (a P/E10 of 25) is 2.9 percent real. The historical data indicates that there was a 20 percent chance that the 20-year annualized return would be less than 0.9 percent real and only a 20 percent chance that it would be better than 4.9 percent real. 6 percent real is better than 4.9 percent real. Either stock investors got very lucky over the past 19 years or the Buy-and-Holders are right that the Valuation-Informed Indexers are exaggerating the importance of taking valuations into consideration when setting one’s stock allocation.
That settles it. The Buy-and-Holders have been proven right by 19 years of data that is more recent and thus more relevant than the historical data employed in Shiller’s research and the follow-up research that has been published in more recent days. Right?
Stocks have done amazingly well over the past 19 years given the valuation level that applied in January 1996. But move forward just four years in your analysis and you see a very different story.
From January 2000 forward, stocks have provided an annualized real return (with dividends reinvested) of 2 percent real. TIPS provided a real return of 4 percent real over that time (for investors who knew as a result of Shiller’s research to look for an alternative to stocks once the P/E10 level reached insanely dangerous heights). That’s double the return for 15 years running! From an investment class of zero risk! If you that presume that comparisons of stocks and TIPS require a 2-percent reduction in the return for stocks to reflect the added risk of this asset class, the return for TIPS was 4 full real percentage points better. TIPS have been TROUNCING stocks for a long, long time now.
The returns that we have seen for stocks for the past 19 years suggest that the core Buy-and-Hold belief that stocks are always the best asset class is sound. The returns that we have seen for the past 15 years suggest that the core Valuation-Informed Indexing belief that prices matter as much when buying stocks as they matter when buying any other good or service is sound.
If you measure from 1997 forward, the return on stocks has been 5.2 percent real.
If you measure from 1998 forward, the return on stocks has been 4 percent real.
If you measure from 1999 forward, the return on stocks has been 2.7 percent real.
Stock prices reached insanely dangerous levels in 1996. But investing in stocks continued to pay off for another year on a risk-adjusted basis and for another two years on a non-risk adjusted basis. From that point forward, Shiller’s finding that valuations affect long-term returns has been strongly confirmed.
Only a small number of Buy-and-Holders have abandoned their strategy as a result of the last 19 years of stock performance. Many are not happy with the results they have obtained for the past 18 years or certainly for the last 16 years. But the 19-year result remains impressive enough that many continue to ignore warnings from Shillerites that valuations must be taken into consideration.
In contrast, the Valuation-Informed Indexers worry that the real message of the past 15 or 16 or 17 years if not quite the past 18 or 19 years is that valuations DO matter, as much today as throughout the entire historical record prior to 1996, it’s just that it can take a good bit of time for the valuations factor to asset itself in a strong enough fashion to cause those who ignore it to regret doing so.
Rob Bennett recorded a podcast titled Beyond Valuations. His bio is here.