Valuation-Informed Indexing #296
by Rob Bennett
Corsair Capital was down by about 3.5% net for the third quarter, bringing its year-to-date return to 13.3% net. Corsair Select lost 9.1% net, bringing its year-to-date performance to 15.3% net. The HFRI – EHI was down 0.5% for the third quarter but is up 11.5% year to date, while the S&P 500 returned 0.6% Read More
There have been two distinct time periods for U.S. investment returns over the past 20 years. For the first four years of that 20-year time-period (January 1996 through January 2000), we saw a total return of 127 percent (this is an inflation-adjusted number, with dividends reinvested). For the latter 16 years (January 2000 through January 2016), we saw a total return of 29 percent.
If you assume that it is economic developments that determine price changes in the stock market, this suggests that the U.S. economy more than doubled over the four-year time-period and then increased by only one-third in the following 16 years, a time period four times greater in length.
Is this even remotely possible? It is not.
There were no economic developments of such great positive power to explain a doubling of the U.S. economy in the years 1996 through 1999. And there were no economic developments of such great negative power to explain why the economy would grow by roughly one-fourth of that amount in a time-period four times longer. These numbers just don’t make sense.
That is, they don’t make sense if you believe in the foundational premise of the Buy-and-Hold Model for understanding how stock investing works — the belief that it is economic developments that cause stock price changes.
My guess is that, if you asked a Buy-and-Holder to explain these numbers, he would say that it is not always actual economic developments that cause stock price changes, that investor expectations play a role. Expectations were high in the late 1990s and have not been as strong over the past 16 years.
That’s a more reasonable explanation of what is going on. But please note the shift that takes place when we go from saying that it is economic developments that cause price changes to saying that it is investor expectations of economic developments that cause price changes. This shift adds investor psychology to the story.
Investor psychology! That’s what the Shiller model points to as the primary influence on stock price changes. Saying that it is investor expectations of economic developments that cause price changes is not at all the same thing as saying that it is economic developments that cause price changes. We have moved from the objective sphere to the subjective sphere. If price changes are caused by economic developments, stock prices are rooted in something real. If price changes are caused by investor expectations of economic developments, stock prices are rooted in feelings, in flights of fancy.
What is the critical difference between the four-year time-period that played out at the beginning of the 20-year time-period and the 16-year time-period that played out at the end of the 20-year time-period? The critical difference is that the years 1996 through 1999 turned up at the end of a huge bull market while the years 2000 through 2015 turned up after a bull market had reached its peak and had begun its gradual descent (which is not yet complete today).
If stock prices are determined by investor expectations of economic developments rather than by economic developments themselves, the stage of the bull/bear cycle in which any particular time-period happens to pop up has a big influence on the price changes that occur in that time-period. Investors have high expectations of the future at the tail end of bull markets, so they push prices up even higher. And investors have low expectations of the future during bear markets, so prices cease upward movement for a long time once bull markets pass their peak.
Now we are beginning to get a handle on why stock price changes have played out the way that they have over the past two decades. Does not the Shiller model better explain the realities than the idea that it is solely economic developments that matter?
Are we saying that economic developments play no role?
Economic developments certainly play a role. Because economic developments affect investor emotions.
But a conclusion that it is investor expectations of economic developments rather than economic developments themselves that determine stock price changes scrambles our understanding of every aspect of how stock investing works. Emotions are not rational. The same economic development could have a small positive effect on prices in one circumstance and a large positive effect on prices in another circumstance. Heck! The same economic development could have a positive effect on prices in one circumstance and a negative effect on prices in another circumstance. Everything that we once thought we knew about how stock investing works is up for grabs as a result of Shiller’s “revolutionary” (his word) research findings of 1981.
The next one should blow your mind. But I think it follows.
The real gain achieved each year should be something close to the average stock-market gain of 6.5 percent real.
Say that we are living through a recession. The old way of thinking about stocks tells us that prices should be low because the underlying companies are less profitable. But most people don’t buy stocks for the returns they will provide over one or two or three years. Most people buy stocks for the long term. So it is the long-term return that matters. Recessions are always followed by recoveries. The investor who buys stocks in a recession is buying the recovery years as well as the recession years. Those recovery years are closer during a recession than they are during a time of heated economic growth (in which case recession years are closer).
The long-term return on stocks purchased during a recession is roughly the same as the long-term return on stocks purchased during an economic boom. The return patterns will differ. In one case, good return years will be followed by poor return years and, in the other case, it will be the other way around. But the good economic years and the bad economic years cancel each other out in the long term and the rational expectation of the long-term return should be roughly the same in both sets of circumstances.
How the economy is doing at the time you purchase stocks doesn’t affect the value proposition you obtain.
What does? The price you pay. It’s valuations that matter. If the long-term return expectation is the same at all times, you want to buy more stocks when the P/E10 level is low than when it is high.
It’s because investors did not know this that the pattern of returns we have seen over the past 20 years is so messed up. Investors kept buying stocks in the late 1990s at the same pace at which they had been buying them when they offered a far better value proposition. The gains of the late 1990s were artificial, the product of emotion. We are now experiencing economic bad times because we need to pay back the trillions of dollars of artificial gains and that doesn’t leave us with enough spending power to make the purchases of goods and services that are the drivers of economic growth.
Rob Bennett’s bio is here.