Valuation-Informed Indexing #333
by Rob Bennett
Stock prices are “sticky.” The point is made effectively in the research paper that I wrote about in last week’s column (“Shiller’s CAPE: Market Timing and Risk”).
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The paper states:
“In Table 6 and Figure 4, we analyze the persistence of CAPE over a period of 10 years. Recall from Table 1 that the average (median) CAPE is 16.2 (15.5). The results indicate that CAPE mean-reverts gradually over time. In CAPE Decile 10, CAPE decreases from 30.2 in Year 0 to 21.7 ten year later, which is still quite high relative to the average CAPE of 16.2. In CAPE Decile 1, the average CAPE increases gradually from 7.4 in Year 0 to 16.2 ten year later. This suggests that prices are not volatile enough relative to long-term average earnings to move CAPE quickly. Thus, as prices move up (or down) gradually over long periods, it takes a while for CAPE to revert back to its mean. This slow price adjustment process helps explain why near term stock returns following high CAPE periods are often not very low. Furthermore, as discussed earlier, even 10- year stock returns following high CAPE periods are often not low, especially relative to the corresponding returns on 10-year Treasurys.”
Many investors disdain long-term predictions. If the claim is made that overvaluation leads to poor returns, they want to see evidence that those poor returns appear within a few months or, at most, within a few years. But that’s not how things usually play out in the real world. Overvaluation (and undervaluation too) can persist for many years. If you move out of stocks when prices reach insanely dangerous levels, you are just as likely to see prices surge upward in their next move as to see them crash downward. Valuations really do predict future return movements. But only the patient investor can reap financial rewards from this reality.
Buy-and-holders take comfort in this reality. They see it as a flaw in the Valuation-Informed Indexing concept that today’s P/E10 value does not tell us much about where prices will stand later this year or next year or in the year after that.
I draw just the opposite moral from the story.
The idea at the root of the buy-and-hold strategy is that price changes are determined by unforeseen economic developments. Unforeseen economic developments should not follow any pattern at all. If prices were determined by unforeseen economic developments, today’s P/E10 value would tell us nothing about where prices will land in future days. But just about everyone now acknowledges that the correlation between today’s P/E10 value and long-term returns is robust. We have won the battle over whether P/E10 is telling us something. The fight that remains is in persuading the buy-and-holders that there is a profit to be made by changing one’s stock allocation in response to the signals sent by changing P/E10 values.
The stickiness of P/E10 values argues against the idea that price changes are determined by unforeseen economic developments. In a market in which prices were determined by unforeseen economic developments, valuations would not be sticky; they would change rapidly as new information arrived to influence the decisions of perfectly rational investors. It is emotions that are sticky, not reasoning. The stickiness of valuation levels tells us that prices are determined primarily by shifts in investor emotions, not by unforeseen economic developments.
Say that you developed an algorithm to reveal the odds that the Boston Red Sox will win their division in next year’s race to the World Series. The team goes on a six-game winning streak. The algorithm recomputes the odds. New information comes in and is properly incorporated into the analysis. Then, the team loses four games in a row. The odds are recomputed in the opposite direction. That’s how a rational process proceeds. There is nothing sticky about it. A rational analysis must be fluid because it must reflect all available evidence, and new evidence is always arriving.
Emotional takes change in a different manner. Say that a fan of the Red Sox develops a love for a particular player. The player enters a hitting slump. The fan makes excuses. He tells himself that the player is just unlucky, or that the weather needs to heat up for him to hit his stride, or that the umpire are being unfair to him. It is only if the player continues for a long stretch of time to break the fan’s heart that he turns on his favorite. At that point, he gives up caring for that player. At that point, he stops making excuses for the player and instead tunes out positive news. He doesn’t want to get fooled again. So now he tells himself that the guy will always be a bum even following games when he gets three hits. Affections are fickle. It’s a thin line between love and hate.
Decisions based on reason are fluid because it is reasonable to change one’s mind when new evidence presents itself. Decisions based on emotion are sticky because it is painful to change one’s beliefs. Stock valuations would change quickly if prices were determined by unforeseen economic developments. They don’t. Stock valuations are sticky. Because prices are determined by shifts in investor emotions – and investor emotions, like all human emotions, are sticky.
The fact that short-term timing does not work is an argument for Valuation-Informed Indexing, not for buy-and-hold. If the market works as the Valuation-Informed Model posits it does, short-term timing should not work.
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