Valuation-Informed Indexing #287
by Rob Bennett
For much of the past decade, Crispin Odey has been waiting for inflation to rear its ugly head. The fund manager has been positioned to take advantage of rising prices in his flagship hedge fund, the Odey European Fund, and has been trying to warn his investors about the risks of inflation through his annual Read More
The last three columns examined a recent article by Michael Kitces (Should Equity Return Assumptions in Retirement Projections Be Reduced for Today’s High Shiller CAPE Valuation?) that advances the highly counter-intuitive and yet entirely accurate 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.”
This changes everything that we once thought we knew about how the stock market works. The old (and still dominant) belief was that stock prices fall in the pattern of a random walk because price changes are caused by economic developments. If what Kitces is saying is so (I strongly believe that it is), prices do not fall in a random walk at all. They play out according to a highly predictable long-term pattern. For about 20 years, valuations rise (with short-term drops mixed in). Then, for about 15 years, valuations drop (with short-term rises mixed in). It is investor emotion that is the primary determinant of stock price changes. Investors can reduce risk dramatically while also increasing return dramatically by adjusting their stock allocations in response to big valuation shifts and thereby keeping their risk profile roughly constant as one “regime” is replaced with another.
This is hard to accept. We are always living through either a high-return regime or a low-return regime. The regimes continue long enough to convince us that they are rooted in something solid and real and permanent, not in something as loosey-goosey and vague and seemingly ephemeral as investor psychology. When sky-high returns were being reflected on our portfolio statements in the late 1990s, we adjusted our understanding of our net worth. But improperly so! A large portion of the oversized returns were the result of the regime we were living through. Those returns were fated to disappear in the following regime. And the poor returns of today’s regime (which began in 2000) will also disappear when we enter the next return-boosting regime.
The strategic implications are far-reaching.
If there really are high-return regimes and low-return regimes, it makes no sense to stick with the same stock allocation at all times. If there are two types of return regimes that last for 15 or 20 years, there are two types of stock markets that last for 15 or 20 years. Decisions that make sense for one of the two types of regimes cannot possibly make sense for the other type of regime. Buy-and-Hold is a mistake. We should be going with higher stock allocations in high-return regimes and with lower stock allocations in low-return regimes.
There’s a rub.
What if the data that Kitces is taking into consideration in forming his conclusions is the product of coincidence? Can we really be sure that the two-regime world will remain in place? If it doesn’t and if we invest on the belief that it will, we will be underinvested in stocks while waiting for today’s low-return regime to play out (the historical reality is that no low-return regime has ever ended until the P/E10 level dropped to 8 or lower, a big drop from where it stands today). Negative consequences follow for an investor who abandons Buy-and-Hold for Valuation-Informed Indexing in the event that Kitces’ regime concept turns out to be an illusion.
The most convincing case that I have seen that it is not an illusion is the case put forward in a book by Michael Alexander titled Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years. Please note that the claim made in the subtitle was widely perceived as crazy at the time it was made (the book was published in 2000) and yet has proven prophetic — stock returns over the past 16 years have been far smaller than the returns that were available in 2000 through the purchase of super-safe asset classes like Treasury Inflation-Protected Securities and IBonds. Buy-and-Holders would have said at the time that a prediction of 16 years of poor returns was exceedingly unlikely to prove valid. And yet Alexander knew something (or at least thought that he knew something) compelling enough to persuade him to put his name to that claim in a very public way.
Alexander engaged in extensive statistical analysis to determine whether stock price changes really do play out differently in different long-term regimes. He concluded that: “The effect of holding time on stock returns in overvalued markets is the opposite of what it is for all markets. Normally, holding stocks for longer amounts of time increases the probability that they will beat other types of investments such as money markets…. In the case of overvalued markets (like today), holding for longer times, up to twenty years, does not increase your odds of success.”
We don’t today know everything there is to know about how stock investing works. We are in the early years of coming to a sound understanding of even the fundamentals. We need to be careful not to jump to hasty conclusions based on limited research. That’s what I believe the Buy-and-Holders did. Many of their insights were genuine and important and have stood the test of time. But the claim that it is safe for investors to ignore price when buying stocks has not stood the test of time.
The Kitces article is pointing us in a new direction. I hope that it generates lots of debate. My guess is that we will not see that debate immediately but that many will be giving the Kitces article a second look following the next price crash, when we will all be seeking to come to terms with what we have done to ourselves by too easily buying into the idea that the stock market is the one exception to the general rule that price discipline is what makes markets work.
Rob Bennett’s bio is here.