Valuation-Informed Indexing #336
by Rob Bennett
My last four columns examined various aspects of a recently completed research paper titled Shiller’s CAPE: Market Timing and Risk. The first column expressed concern re the paper’s finding that never before in U.S. history have we seen today’s extremely high valuation levels apply for so long a time-period. The second column looked to the research paper’s finding that overvaluation is “sticky” and argued that this is because stock prices are set by shifts in investor emotions and investor emotions are sticky. The third column explored the headline finding of the paper — that it generally does not pay for investors to engage in valuation-based market timing (Valuation-Informed Indexing). The fourth column explored the research paper’s assertion that, if it is not possible to use valuation-informed strategies to profit from market timing, the market is efficient; I argued that there would be great benefits to valuation-informed investing strategies even if market timing did not work.
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This week I would like to explore one final question raised by publication of the new research paper. It is raised only in a throwaway comment. But I think it is important. And I think that the fact that the question has been generally overlooked should raise concerns in our minds that we have as a society become complacent in our understanding of how stock investing works and that we are today too little alarmed by the forceful challenges that Robert Shiller’s research has raised to the dominant Buy-and-Hold school of thought.
The throwaway comment is set forth early in the paper. The authors state in their Introduction that: “Market timing strategies using CAPE should not be profitable. However, we are not aware of any formal tests of such strategies.”
At least one formal test has been done. I know because I played an important role in seeing that it was done. I argued in a post that I put to a Motley Fool discussion board on the morning of May 13, 2002, that the Buy-and-Hold retirement studies cannot be accurate because Robert Shiller showed in 1981 that valuations affect long-term returns and the Buy-and-Hold studies do not contain adjustments for the valuation level that applies on the day the retirement begins. Many community members responded in an extremely positive way to the debate that followed, which led to my decision to begin writing this column seven years ago. Other community members responded in an extremely negative way. I have been banned at over 20 discussion boards and blogs in the 15 years since my decision to advance that fateful post.
I didn’t realize that I was saying something so controversial. I thought that it was common sense that, if valuations affect future returns, studies of the likely success of retirement plans must consider valuations. When I saw how much controversy was sparked by this simple observation, I searched the internet to find sites that explore the practical implications of Shiller’s “revolutionary” (his word) finding. There are none! I began doing the work I do today — exploring those practical implications myself.
An academic researcher named Wade Pfau discovered my work through my posting at the Bogleheads Forum and told me that he was greatly excited by the Valuation-Informed Indexing concept and would like to work with me to develop research showing that long-term timing works. Our paper (Wade is the official author, I am named in the “Acknowledgements” section) was published in a peer-reviewed journal. It shows that “Valuation-based market timing demonstrates strong potential to improve risk-adjusted returns for conservative long-term investors.”
It’s amazing stuff. When Wade posted about it at the Bogleheads Forum, one poster commented (I am paraphrasing) that the new strategy “turns most of what we learn about stock investing at this forum on its head.” I think that’s right.
It’s not my intent here to find fault with the authors of the new paper for not knowing about the earlier one. Lots of research papers are published in this field. The Valuation-Informed Indexing paper has received only limited attention.
My question is — Why?
I believe that the paper should have been featured on the front page of the New York Times. I hope that you won’t view that as bragging. I believe that the new paper is important too; I showed that by devoting five columns to analysis of various aspects of it. I also believe that numerous papers should have been published examining how to profit from long-term timing long before I came on the scene. If Shiller is right, stock investing risk is not static but variable. That reality really does turn all our ideas about how stock investing works on their heads.
When Wade learned about Valuation-Informed Indexing, he was amazed that there were not hundreds of people already writing about it and researching it. He never learned about the concept when acquiring his Ph.D. at Princeton. Why? When he did the research showing that the concept works, he wrote me an e-mail proclaiming: “Yes, Virginia — Valuation-Informed Indexing works!” He told me that he was missing sleep because of the excitement he felt over being one of the pioneers to explore this new territory.
Don’t other people in this field want to be pioneers?
I know today why lots of good people hold back. Pioneers often get arrows shot at them. It hurts.
But it’s an exciting business all the same. I need competition. My background in this field is limited. I would benefit from having lots of smart people critique the work that I have done over the first 15 years of my explorations. Wade has the Ph.D. that I lack but he would benefit from more feedback too. As would the authors of the new study. As would lots of others. All of us, really.
Shiller might be wrong. Or it might be that those of us who have taken the lead in exploring the practical implications of his amazing findings have made mistakes that will be uncovered in time. That’s all part of the game.
But I do think that we should see more work being done in this area. Shiller showed that valuations affect long-term returns in 1981. If that’s so, long-term timing should work. It’s now 2017. We shouldn’t be seeing the researchers of today saying that they have not been able to find research exploring the question of whether long-term timing works or not. We all need to get to work digging deeper.
Rob’s bio is here.