Valuation-Informed Indexing #286
by Rob Bennett
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
The last two 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 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.”
It’s not just that stock returns fail to fall in the pattern of a random walk (which would have to be the case for the Buy-and-Hold strategy to work for long-term investors). Throughout the entire history of the U.S. stock market, returns have been playing out in what intuitively would be a highly improbable pattern. Valuations go up, up, up (with short-term downs mixed in) for about 20 years, and then down, down, down (with short-term ups mixed in) for about 15 years. Risk changes with valuations shifts. Investors who aim to keep their risk profiles roughly constant by changing their stock allocations in response to big valuations shifts are thus able to reduce risk by 70 percent while earning far higher lifetime returns.
The mystery is — Why hasn’t the idea of doing so caught on?
The trouble is — making sense of the last 34 years of peer-reviewed research requires giving up the core belief on which we have long based our understanding of how stock investing works. We like to think of stock investing as a rational enterprise. Our retirement money is at risk. We want to have confidence that, when we look at the numbers of our portfolio statements, they mean something. We want to believe that our financial plans are rooted in hard realities.
The last three decades of peer-reviewed research is telling us that they are not. If stock investing were a rational enterprise, it would not be possible for valuations to predict long-term returns. If the market were efficient, mis-pricing would not exist. It would not signify anything to say that the market is overvalued or undervalued. If investors were rational, stocks would always be priced right. That’s not the world we live in.
It could be in the future, though. We could make it that. Ironically, there is only one thing stopping Buy-and-Hold from being the ideal strategy. The thing that makes Buy-and-Hold dangerous is the insistence of the Buy-and-Holders that it is okay for investors to stick with the same stock allocations at all times.
Consider how other markets work. Buyers of goods want the lowest possible price. Sellers want the highest possible price. They engage in a dance of negotiation. The end product of that dance is a fair-market-value price. Sellers who get too greedy cannot attract buyers and are driven out of business. Buyers who get too greedy cannot find sellers and are left without possession of the product they desire. Markets work their price-setting magic through use of the natural tension between buyer demands for low prices and seller demands for high prices.
That’s how it works in every market except the stock market. When was the last time you heard a stock investor cheer a price drop because it meant that he could now obtain stocks at a lower price?
You will sometimes see this with educated buyers of individual stocks. A value investor will determine that a particular stock is a good buy at x price and wait for the price to drop to that level before buying. That’s the way of thinking about stock buying decisions that makes the market work effectively.
But today we have millions of people buying stocks who never exercise any price discipline whatsoever. Millions of middle-class investors buy stocks with each paycheck as a means of financing their retirements. They don’t research particular stocks, they buy index funds. And they cheer every price jump. They measure success by how much their portfolio value increases. They view price drops not as a buying opportunity but as a failure. They like overpaying for stocks!
This is what needs to change. There is no natural brake on stock overvaluation. It always gets out of hand. So long as investors view overpricing as a good thing, the inventive for more overpricing is too powerful to overcome. Sooner or later prices will reach insanely dangerous levels. Then there will be a price crash, taking trillions of dollars of consumer spending power out of the economy. Hundreds of thousands of businesses will fail when consumers can no longer afford their products. Millions of workers will lose their jobs. Political stresses will evidence themselves.
All of this is optional now that Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns is available to us. We now know how to add price discipline to the stock market and thereby to do away with the source of its dysfunction.
The historical return data tells us how much valuations affect long-term returns. We could tell people. Instead of encouraging investors to ignore valuations and to stick with the same stock allocations at all times, we could encourage them to always, always, always be certain to adjust their allocations in response to big valuation shifts so that their risk profiles remain roughly constant. Every upward tick in valuations would be met with enough sell orders to generate a downward tick of equal power. No more bull markets. No more bear markets. No more economic crises.
They say that there is no such thing as a free lunch. That’s not entirely true. Learning is a free lunch. The Buy-and-Holders launched a huge learning experience when they argued that we should all look to peer-reviewed research to guide our investing decisions. That’s the part of the Buy-and-Hold Model that has proven to be pure gold. We need to listen closely to what the Buy-and-Holders were saying in the days before 1981 to come to understand why it is so important that they be challenged re the things that they have been saying since 1981.
Please read the Kitces article again. Think through what it signifies. This is a big deal. This is a turning point. This is a game-changer.
Rob Bennett’s bio is here.