Valuation-Informed Indexing #285
by Rob Bennett
Last weeks column examined a recent article by Michael Kitces (Should Equity Return Assumptions in Retirement Projections Be Reduced for Today’s High Shiller CAPE Valuation?) that advanced the amazing (but entirely true) claim that: The ideal way to adjust return assumptions…[may be] to do projections with a ‘regime-based’ approach to return assumptions. This would entail projecting a period of much lower returns, followed by a subsequent period of higher returns.”
GrizzlyRock Value Partners was up 34.54% net for 2021. The fund marked 10 years since its inception with a 198% net return, resulting in an annual return of 11.5%. GrizzlyRock enjoyed 14.8% long alpha against the S&P 500 and 26.9% against the Russell 2000. Q4 2021 hedge fund letters, conferences and more The fund's short Read More
Stock returns do not play out in the pattern of a random walk. Not at all. The same pattern has been repeating for the entire 145 years of return data available to us today. Valuations move steadily up for a long time, perhaps 20 years. Then valuations move steadily down for a long time, perhaps 15 years. When valuations are very high, as they are today, you should expect 10-year returns to be low. But 30-year returns will be better. After the passage of 15 years or so of poor returns, a new period of gradually increasing valuations kicks in, countering the effect of the 15 years of poor returns. By the end of 30 years, the overall return may not be so bad.
This is strange stuff.
It’s one thing to agree that valuations affect long-term returns. That wouldn’t be possible if the market were efficient, as was once believed to be the case. But most investors have come to accept that Shiller is right that valuations matter; prices matter in every other market that exists, so it is not hard to understand that they would matter in the stock market too. But it’s something else to say that prices go up, up, up for many years and then down, down, down for many years. What’s that about?
I was shocked by this result when I discovered it through my work with John Walter Russell at the old Safe Withdrawal Rate Research Group discussion board. Investing experts who engage in technical analysis are often ridiculed by investing experts who instead believe that market prices are determined by economic factors as engaging in some sort of voodoo. Citing return patterns sounds about as scientific as predicting a person’s future by asking him what Zodiac sign he was born under. It sounds too “out there.” This was my first reaction when John’s research revealed the pattern that has been governing stock prices for the entire history of the U.S. market.
But puzzles bother me. When there is some facet of a phenomenon that I do not understand well, I find my mind returning to it again and again, searching for a reasonable explanation. Until all puzzles are resolved, I worry that I do not understand the matter under consideration as well as I need to to possess confidence in my beliefs about it. So for several years I found myself often wondering why the reality that Michael Kitces points to in his recent article is indeed a reality.
Why do stock valuation levels head upward for a long time (with temporary drops mixed in, to be sure) and then head downward for a long time (with temporary rises mixed in). What could explain such a pattern?
I often comment at this column how Shiller described his 1981 finding that valuations affect long-term returns as “revolutionary.” I believe that it really is that. I believe that what Shiller showed is that our fundamental belief about what causes changes in market prices is in error. The common and long-held belief is that it is economic realities that cause stock prices to change. What Shiller showed is that that is not so. If it were economic realities causing stock price changes, future returns would not be predictable because future economic realities are of course not predictable. If future returns are highly predictable, as Shiller showed, it must be something else causing stock prices to change.
It’s investor emotion that is the primary cause of stock price changes, not economic realities. That’s the Shiller breakthrough. That changes everything.
The strange pattern described in the Kitces article makes sense once you accept that it is investor emotion that is the primary cause of stock price changes.
The key reality of the stock market is that it is stock investors who set prices. By bidding up or bidding down prices, we can collectively see to it that our portfolios reflect our personal desires. The economic realities don’t really matter. If we all want to retire early (and who doesn’t?), there’s nothing stopping us from bidding stock prices up to two times fair value or even to three times fair value. Stock investors can as a group collectively grant themselves raises at any time they please. Is that not so?
There must be some limit on this power we possess to vote ourselves raises. If there were no limit, we would not stop at increasing stock prices until valuations were at three times fair value (as they were in early 2000). We would take them to four times fair value, then five times fair value, then ten times fair value. Why not?
The full reality is that, while we all possess a Get Rich Quick urge that prompts us to push stock prices higher until they reach two times fair value or perhaps three times fair value, we all also possess common sense, which makes us fearful of additional price increases once valuations have risen to insanely high levels. After about 20 years of rising valuations, the collective investor psychology always flips and instead of pushing prices up, up, up, we begin pushing them down, down, down.
After a complete cycle has been completed, the long-term return for the cycle is always something in the neighborhood of 6.5 percent real, the long-term average return justified by the U.S. economic realities for as far back as we have records. So the strange reality explained by Kitces in his article applies: high valuations assure low returns 10 years out but returns closer to average for time-periods of 30 years or more. High-return periods are always followed by low return periods and low return periods are always followed by high return periods.
The strategic implications are far-reaching. We once thought that stock investing risk was constant; it’s not — it’s variable. We once thought that investors should stick with the same stock allocation at all times. That’s wrong; investors who want to maintain the same risk profile MUST change their stock allocations in response to big valuation shifts to do so. We once thought that stocks were an inherently risky asset class. That’s not so. Investors who invest more heavily in stocks when valuations are low than they do when valuations are high earn higher long-term returns while reducing risk dramatically.
I believe that Michael’s article will be the subject of widespread discussion following the next price crash. This is exciting stuff. This is the future.
Rob Bennett’s bio is here.