Valuation-Informed Indexing #309
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
This is my fourth column commenting on a recent article published in the Wall Street Journal by Wade Pfau (What Is the Sustainable Spending Rate for Retirees in 2016?). I saved the most exciting one for last.
Please follow the link above, scroll a tiny bit down the page and take a long, hard look at that graphic. It tells the story that I am always going on about but that as a society we have elected not to focus in on for the 35 years since Shiller published his “revolutionary” (his word) research showing that valuations affect long-term returns.
It’s easy to miss the most important point made by the graphic so please don’t make the mistake of skimming over it and permitting yourself to be pulled back too quickly by the narrative of the article. You need to look at the graphic and think through its many implications. When it hits you what Wade is showing us here, the reality will knock your socks off. This is amazing stuff.
There are two compelling points being made, actually.
The graphic compares “Predicted Withdrawal Rates” with “Actual Withdrawal Rates”. The two lines follow each other closely for the entire time-period for which we have return data available for examination. That’s huge. It means that we can effectively predict the withdrawal rate that will apply for a retirement on the day the retirement begins. We didn’t think that was possible in the days before Shiller published his research (in the dark ages prior to 1981, we thought that it would be okay to suggest the same withdrawal rate at all times). Wade is showing that now it is possible to make effective predictions.
Another way of saying it is that we can now reduce the risk of retirement failure in a dramatic way. Reducing risk is the primary purpose of retirement planning. And we can now perform this task far better than anyone imagined possible in the days before we knew that valuations affect long-term returns. I wish that we could all step back for a moment from the controversies that rage about us and just let in the positive significance of this astounding good news. Sometimes a society achieves a major advance. This is one of those times.
The second amazing point made by the graphic is that valuations plays a far bigger role in investing success than any of us realized in earlier days. The maximum sustainable withdrawal rate reported by Wade is 9 percent. The lowest predicted withdrawal rate is 3 percent. That’s a difference of 300 percent. Caused by one factor — valuations (it’s two factors if you count interest rates as a separate factor). Wow. Did anyone believe in 1980 — the high-water mark for belief in the Efficient Market Hypothesis — that the value proposition offered by stocks changed by a factor of 300 percent when valuations moved from lows to highs?
Shouldn’t that change our understanding of every possible strategic question in a dramatic way?
It seems so to me.
Stocks do not offer the same returns when they are priced high as they do when they are priced low. Stocks are not as risky when they are priced low as they are when they are priced high. The higher returns provided by stocks add to the spending power of millions of investors in the years following extreme lows and the lower returns provided by stocks subtract from the spending power of millions of investors in the years following extreme highs. So bull markets cause economic bad times and bear markets put the conditions in place that eventually lead to economic good times.
Does all of that not follow?
I have had a hard time getting a national debate launched re these questions but my brain continues to tell me that they are important questions that need to be examined by lots and lots of smart people. I quote Shiller’s comment that his findings are “revolutionary” (he used this word in the subtitle of his book) in most of my columns because I believe that his use of that word is not even a tiny bit of an overstatement. I believe that his finding that long-term returns are predictable and that stock investing risk is thus not static but variable is a paradigm changer. I don’t think that it gets any bigger than this. I see this as the future of investing analysis.
Please understand that it is Rob Bennett saying these things about Wade Pau’s graphic, not Wade himself. I believe that, if you asked him privately, Wade would agree with the thrust of what I am saying. We exchanged hundreds of e-mails during the 16 months that we were working together and he told me during that time that he was so excited about what he was finding in his research that he could hardly sleep at night. He once exclaimed bluntly: “Yes, Virginia — Valuation-Informed Indexing works!” But for now Wade is letting his graphic do the talking for him — that alone shows that he is a lot smarter than his old friend!
That graphic makes the case for Valuation-Informed Indexing. If it really is true that long-term returns are predictable and that risk is variable, the strategies that we once thought made sense no longer do. Buy-and-Hold just doesn’t cut it in a world in which the value proposition of stocks changes by a factor of three depending on the price at which they are selling.
Shiller’s research changed everything. Pfau’s graphic shows why. Now all that is left to the rest of us is to work up the courage to begin talking about the big advance and thereby enriching our understanding of it and then to get about the business of getting the word out to everyone who wants to reap the benefits of our collective good fortune.
Rob Bennett’s bio is here.