It Was the Widespread Belief in Buy-and-Hold Strategies That Caused the Runaway Bull Market

Valuation-Informed Indexing #340 on cape ratio

by Rob Bennett

Barry Ritholtz recently published an article that at least on the surface makes a compelling case for following Buy-and-Hold investing strategies.

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Barry wrote: “If I wanted to scare people, I could selectively pull data showing that at present we have the highest [P/E10] reading outside of 2000 (43.2), 1929 (32.5) and 2007 (27.6). But cherry-picking dates to scare people is bad form, and I prefer to use the data to look for evidence. What does it show? Since 1990, the S&P 500 has traded above the average CAPE ratio in 307 of 324 months — that’s 95 percent of the time. If you abandoned U.S. equities when the CAPE ratio was overvalued, you would have missed gains of more than a 1,000 percent over that time. In fact, had you only invested when the CAPE was 25 percent overvalued — i.e., when stocks were simply “expensive” — your total returns since 1990 would have been 650 percent. This is one of many reasons it is ill-advised to use valuation as a timing mechanism.”

He added that: “ The most I can say about higher-than-average valuations is that when the CAPE ratio is significantly above its long-term average, you should lower your expectations for future returns. In other words, if the 100-year average S&P 500 return with dividends reinvested is about 10 percent, you should expect average equity returns over the next five to 10 years to be somewhat lower. That doesn’t mean we won’t see good or bad returns in any given year; when the CAPE has been over 25 in the past, over the next five years returns ranged from 18.7 percent to negative 17.4 percent a year. The same returns when CAPE was in the five to 10 range were 10.3 percent to 36.1 percent. Hence why I suggest you should ratchet down your expectations.”

I want to scare people.

I appreciate the point that Barry is making. Millions of good and smart people believe what he believes. And it of course could be the case that those millions of smart and good people have nailed it and that I am a fool for questioning their wisdom. But I really do have my doubts. And in the event that I am the one who has nailed it, those millions are in for a good bit of pain down the road a piece. So I would feel that I was not living up to my responsibilities to my Buy-and-Hold friends to fail to give voice to my concerns.

It’s the “since 1990” thing that is the source of my concern. The core point that is being made here — that stock valuations have remained high for a very long time — is 100 percent correct. I prefer to start counting in 1996 since prices were only high but not yet insanely high until then. But even using the later starting date leads to a finding that prices have remained dangerously high for two decades. If the danger warned of by Valuation-Informed Indexers has not wiped out investors in that amount of time, is it not fair to conclude that the dangers being warned of are not real? I have been crying “wolf!” since 1996. There comes a time when people stop listening to the boy who cries “wolf!” for a long time. Twenty years of false wolf warnings are enough to conclude that no wolf is coming.

Unless there is some explanation for why the wolf has taken longer to arrive this time than he has on any earlier occasion.

Say that Shiller cape ratio is right. Say that changes in stock prices are caused not by economic developments but by shifts in investor emotion. How would that work? The default case would be that stock valuations would keep rising and rising. Increases in stock valuations make everyone happy. Personal finance journalists sell more papers when prices are rising quickly. Investors are happy with their advisors when prices are rising quickly. Everybody wins and so there is nothing to stop the train from moving forward at faster and faster speeds.

Actually, there is one thing. Investors possess common sense. They know that in every market other than the stock market it is critical to exercise price discipline when deciding whether to make purchases of the product being offered for sale. Eventually common sense comes to exercise influence even in the stock market. Eventually, prices return to fair-value levels because, after all, it is the very purpose of a market to get prices right.

This understanding of how markets work is supported by the historical return data going back to 1870, which is as far back as we have good records.

Now say that a model for understanding how stock investing works was developed in the late 1960s and then achieved a measure of acceptance in the 1970s and then achieved widespread popularity in the 1980s and 1990s. Say that the claim was made by many experts in the field that this model was backed by peer-reviewed research. Say that this model taught investors that there is never a need for them to lower their stock allocations no matter how high price go. That would explain the long time-period in which prices have not fallen hard without justifying Barry’s conclusion that investors should not be adjusting their stock allocations in response to big price shifts.

Barry’s article makes a compelling case for Buy-and-Hold for those who already believe in Buy-and-Hold strategies. It does not do the job for those who believe in Valuation-Informed Indexing strategies. For those who believe that valuations affect long-term returns, the fact that prices have remained so high so long is not a sign that prices don’t matter any more but as a sign that investors have in recent decades engaged in more self-destructive behavior than they engaged in at any earlier time in U.S. history, that we have set ourselves up for more financial losses than those that brought on the Great Depression.

If the market really is efficient, the Buy-and-Holders have been doing the right thing for the past 20 or 30 years. If Shiller is right about what causes stock price changes, it was the widespread belief in Buy-and-Hold strategies that caused the runaway bull market that brought on the economic crisis that we are living through today and that still has a long way to run before we are finished paying the price for letting that bull market get so out of control.

Rob’s bio is here.