Valuation-Informed Indexing #300
by Rob Bennett
Robert Shiller’s 1981 finding that valuations affect long-term returns changes everything that we once thought we knew about how stock investing works. If return expectations are not constant, risk is not constant. If risk is variable, investors who want to keep their risk profiles constant must avoid keeping their stock allocations constant (that is, they must engage in long-term market timing). If big return jumps are a bad thing (since they cause lower returns going forward), bull markets are a bad thing.
Odey's Brook Absolute Return Fund was up 10.25% for the third quarter, smashing the MSCI World's total return of 2.47% in sterling. In his third-quarter letter to investors, which was reviewed by ValueWalk, James Hanbury said the quarter's macro environment was not ideal for Brook Asset Management. Despite that, they saw positive contributions and alpha Read More
Bull markets hurt investors. That’s a clear implication of Shiller’s “revolutionary” (his word) finding.
The key to having this sink in is thinking through what Shiller’s finding says about what causes price changes. Investors have long loved bull markets because they have long believed that price changes are caused by economic developments. Under this way of thinking about how the market works, rising prices signal improving economic conditions. Bull market gains are free money, according to this model. Investors were expecting the average return of 6.5 percent real. But the market outpaced that target. If it is economic improvements that cause market gains, it follows that the economy is doing better than expected. Everybody wins when the economy improves. Investor love of bull markets is perfectly understandable so long as one’s belief in Buy-and-Hold remains strong.
But Shiller has thrown the old beliefs into question. Today’s P/E10 level tells us nothing about how the economy is going to be performing in 10 years. So how is it that today’s P/E10 level tells us something important about what returns will be over the next ten years? Shiller discredited the idea that it is economic developments that cause price changes. It is investor emotion that causes overvaluation. If overvaluation is real, as Shiller showed, it is investor emotion that is the dominant influence on price changes (although it is of course entirely possible and even likely that economic developments still have some influence because they have an influence on investor emotions).
If bull markets are the product of investor emotion, then all that is going on is that investors are borrowing gains from the future to pump up gains artificially in the present. Investors who view bull market gains as real gains are like consumers who take out large amounts of credit-card debt to enjoy a better life than they can afford with money earned from their jobs. Bull markets are not a good thing if all of the excess gains they produce have to be paid back in future years in which returns will be as much below average as they are in the current day above average. Bull markets don’t only cause stock crashes. They cause recessions.
Most investors cheer on bull markets. The job of investing experts is to teach them why this is a mistake. That’s the purpose of The Returns Sequence Reality Checker.
The idea that bull markets are bad news is a highly counter-intuitive one for those who have had the Buy-and-Hold concept impressed on their brains for decades. But the idea actually makes a good deal of sense once you manage to let go of preconceptions and look at the question with a fresh perspective.
When you are in the market for a car, do you pray that prices will rise sharply before you make your purchase? You don’t. It would be silly to do so. This is so obvious.
Most of us buy stocks on a regular basis, directing a portion of our bi-weekly paychecks to this purpose. Why do we root for stock prices to go up before we make our next purchase? Isn’t this backwards? We should want stock prices to fall.
We obviously don’t want stock prices to fall forever. We become net sellers at some point in retirement. Sellers should of course want prices to rise. But most of us are net buyers of stocks for most of our lifetimes. Buyers of stocks should want prices to fall, just as buyers of any other good or service want the price of that good or service to fall. It is better to buy stocks at low prices than at high prices. You can buy more stocks with the same amount of money when they are available for sale at low prices.
The Reality Checker assumes that stock prices will over 30-year time-periods continue to rise at 6.5 percent per year, as they have for 145 years now. It lets investors know how returns sequences experienced for a portion of a 30-year time-period affect the return experienced for the remaining years of the 30-year time-period.
Imagine two investors who starts with a portfolio value of $10,000 and then add $10,000 in contributions for every year of a 30-year returns sequence. Say that one of the investors experiences 10 percent gains for each of the first ten years of the 30-year sequence and that the other investor experiences 10 percent losses for each of the first 10 years of the 30-year sequence. The return sequence beginning with 10 years of gains produces a closing balance of $796,051. The returns sequence beginning with ten years of losses produces a closing balance of $2,435,295. Bear markets pay off big-time for long-term investors. You’ll be able to retire much sooner if only you are lucky enough not to live through a prolonged bull market like the one we saw come to an end in January 2000.
It turns out that the stock market works just like every other market that has ever come into existence. Price drops are good news. Price increases are bad news. Time periods in which we see one price increase after another for many years in a row (bull markets) are horrible setbacks for us all. It all works just the opposite from what the Buy-and-Holders have been saying for 50 years now.
Now we need to get the word out!
Note: Sam Parler was the co-developer of the Reality Checker.
Rob Bennett’s bio is here.