Valuation-Informed Indexing #352

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by Rob Bennett

When someone expresses a concern about the mispricing of stocks, it is almost always a concern about the effects of overvaluation. Overvaluation causes stock crashes. Overvaluation causes failed retirements. Overvaluation causes economic crises. Blah, blah, blah. You know the drill.

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I have expressed concern about those sorts of things on numerous occasions. I think that mispricing on the high side is a very bad thing. As stock prices rise, the long-term return on stock investments drops. Millions of us are depending on good stock returns to finance our retirements. To live in times of high stock prices is to live in times when it is difficult to finance a safe retirement effectively. We would all be better off if stock prices remained at something close to fair-value levels at all times and we saw steady annual returns of something in the neighborhood of 6.5 percent real instead of the crazy upward movement in prices followed by a crazy downward movement in prices that we see when too many investors become indifferent to valuation concerns.

But I have come over time to believe that undervaluation is as big a problem as overvaluation. The full reality is that overvaluation and undervaluation are two sides of the same emotional-investing coin. Overvaluation causes undervaluation and undervaluation causes overvaluation. The two phenomena work together to mess with our minds, to make it hard for us to appreciate what is going on when we invest our savings in stocks with the hope of using the gains produced over time to finance our old-age retirements.

The highest P/E10 level that we have seen was the 44 that applied in January 2000. The lowest P/E10 that we have seen in recent history was the 8 that applied in 1982. In 2000, the most likely 10-year annualized return on U.S. stocks was a negative 1 percent real. In 1982, the most likely 10-year annualized return was 15 percent real. It's not hard to see the dangers inherent in the former scenario. When the asset class in which most of us have most of our retirement money invested is generating a negative long-term return, we are all in for a lot of financial suffering. In contrast, a return of 15 percent real for 10 years running sounds pretty darn good. How can I say that undervaluation is as bad as overvaluation?

To see the problem with undervaluation, you have to look beyond the return being obtained on your investing dollar and consider the effect that such valuation levels have on our national economy. I often remark on how crazy it is that we priced stocks at three times their real value back in early 2000. That is indeed crazy. But I think a case could be made that our collective pricing choice was even more off the wall in 1982. At that time the entire market was priced at one-half of its true, lasting value. Shares in hundreds of thousands of businesses were selling at only 50 percent of their genuine economic value. A decision to underprice the assets that we all rely on to generate future wealth to that extent causes a lot of human misery.

When the market is priced at one-half of its real value, millions of people who could be productively employed are left without jobs because the businesses that would be happy to hire them in a world where stocks were priced properly do not have the finds needed to pay them.

When the market is priced at one-half of its real value, thousands of entrepreneurial projects that would make all of our lives better in thousands of different ways don't get off the ground because the executives who would need to set aside money to finance them in their start-up years don't dare risk the capital needed to do so because money is so tight.

When the market is priced at one-half of its real value, millions of people who otherwise might be good savers lose confidence in the saving project because their stock investments of earlier years have offered such disappointing returns.

Those 15 percent returns aren't looking so hot anymore, are they?

It's not overvaluation that is bad. It is the





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