Valuation-Informed Indexing #280
by Rob Bennett
Valuation-Informed Indexing is the future.
Paul J. Isaac's Arbiter Partners returned -19.3% in the third quarter of 2021, according to a copy of the hedge fund's quarterly investor correspondence, which ValueWalk has been able to review. Following this performance, the fund's return sits at -1.6% for the year to the end of September. In comparison, the S&P 500 returned 15.9%, Read More
Buy-and-Hold is the past.
Or at least so I believe.
But as of today Buy-and-Hold is far more popular. About 80 percent of stock investors do not believe that it is necessary for them to change their stock allocations in response to big valuation shifts. Another 10 percent see the merit of the idea but are reluctant to adjust their allocations too much because few investors do this and they see risk in going against conventional opinion. About 10 percent follow a Valuation-Informed Indexing strategy.
I want to spread the word about the new model, which I view as the first true research-based strategy (because Shiller’s 1981 finding that valuations affect long-term returns discredited the belief rooted in Fama’s research that the market is efficient). So I need to point out the dangers of Buy-and-Hold.
I wish that it weren’t so. I greatly admire the Buy-and-Hold pioneers. I buy into all of their beliefs except for the one about there being no need for investors to take price into consideration when buying stocks. Moreover, the 80 percent who believe in Buy-and-Hold are offended when I find fault with the strategy. If there were some way to make the case for Valuation-Informed Indexing without criticizing Buy-and-Hold, I would win over a lot more people and encounter a lot less friction as a result of my efforts to do so.
It can’t be done. Fama said that the market is efficient. That means that stocks are always priced properly. Buy-and-Holders often object to that statement. They say that an efficient market is just one in which all available information is incorporated into the price but that the price that results is not necessarily the right one. That’s a hyper-technical distinction. If the market price incorporates all known information, the market price is as close to perfect as it could possibly get. Buy-and-Holders are essentially saying that the market price is always right.
If the market price is always right, indicators of overvaluation and undervaluation are meaningless. Buy-and-Holders don’t consider valuations when buying stocks for a logically sound reason. They don’t believe that valuation metrics tell us anything. According to the Buy-and-Hold model, the P/E10 value is noise.
Shiller showed that the P/E10 value is not noise. It effectively predicts long-term returns.
By undermining the foundational belief of the Buy-and-Holders, Shiller turned our understanding of how stock investing works on its head. It’s not true that stocks are risky; the risk largely goes away for investors who take valuations into consideration when buying stocks. It’s not true that the safe withdrawal rate is the same number for all retirees; the safe withdrawal rate is a number that ranges from 1.6 percent when stocks are priced as they were in 2000 to 9 percent when stocks are priced as they were in 1982. It’s not true that bad economic times cause stock crashes; stock crashes become inevitable once over-valuation gets too out of control and the losses experienced in the crashes cause consumer spending power to dry up and the economy to falter.
Shiller’s finding is all positive. It’s like the discovery of electricity; it leaves us all big winners. But it represents a big change. Shiller’s finding will eventually take us to a very good place but starting a national debate re the implications of his finding has been a disruptive experience. How people invest to finance their retirements is an important and sensitive matter. Telling people that they got it all wrong upsets them. People want to move forward in their understanding. But it hurts them to let in the knowledge that they could have earned higher lifetime returns at less risk had they caught on to the significance of the Shiller revolution earlier in life.
The normal way for a new idea to catch on is through exposure in the marketplace of ideas. When the Beatles showed up on the Ed Sullivan show with their long hair, a debate was launched as to whether it was okay for men to wear their hair at that length. Arguments were advanced from both sides of the divide in opinion. Eventually a resolution was reached in the minds of most people. The Beatles won that one (for the most part but not entirely). Most people of today find long hair acceptable on men.
The big problem in the investing realm is that the debate has not yet been successfully launched. People who believe that valuations matter keep quiet about it when they are speaking in the presence of Buy-and-Holders. It is viewed as rude to mention how dangerous Buy-and-Hold will prove to be if it turns out that Shiller really is on to something.
There’s no way to know for certain that Shiller is right. The historical data supports him. But data from earlier times can be dismissed on the grounds that the economic conditions under which that data was produced no longer apply. And the data from the time of Shiller’s finding until today is inconclusive. From 1981 forward, Buy-and-Hold has performed slightly better than Valuation-Informed Indexing. Valuation-Informed Indexers say that that’s because stock prices are high today; Valuation-Informed Indexing will be revealed as the superior strategy with the next price crash, which is inevitable according to the Shiller model. But that way of thinking about things begs the question — to say that Valuation-Informed Indexing will prove superior because today’s valuations will produce another crash is to say that Valuation-Informed Indexing will prove superior once again because Valuation-Informed Indexing has always been superior. The crash hasn’t come yet. So we don’t know for certain.
To be fair, the Buy-and-Holders are begging the question too. They say that we cannot know that another crash is coming soon because the market is efficient and returns are thus not predictable. All of the beliefs of those following both strategies follow from their core premises. If the market is efficient, Buy-and-Hold is the ideal strategy. If valuations affect long-term returns, Buy-and-Hold is dangerous.
I believe that I need to point that out to my Buy-and-Hold friends. I don’t want to hurt their feelings. I want them to consider what might happen to their retirement portfolios if it turns out that Shiller is right. I criticize their strategy not to upset them but to alert them to a new way of thinking about how stock investing works that I strongly believe we all need to know about.
Rob Bennett’s bio is here.