Valuation-Informed Indexing #368 on the U.S. market versus global markets
By Rob Bennett
A thread that should be of interest to valuation-informed investors was recently posted to the Bogleheads Forum. It is titled History of World Stock Market Bubbles. 1900-2014, and argues (based on an historical study of u.s market bubbles around the world) that: “Most large increases in price are not followed by huge crashes. In fact the opposite is true: large price increases are more likely to be followed with further large price increases, not crashes.”
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Specifically, the study (by William Goetzmann of the Yale School of Management) examined 72 cases where markets more than doubled in one year; after five years, about 15 percent had crashed to less than 50 percent of their value while over 26 percent of these markets had at least doubled again in value.” Goetzmann concluded that: “Placing a large weight on avoiding a bubble, or misunderstanding the frequency of a crash following a boom, is dangerous for the long-term investor because it forgoes the equity risk premium.”
Most investors who post at the Bogleheads Forum are Buy-and-Holders. They generally took comfort in these findings because they suggest that, even at times when irrational exuberance takes hold of a u.s market to the extent needed to cause a doubling of prices in a single year, the value proposition for stocks remains strong enough that investors make a mistake to lower their stock allocations. I certainly don’t agree with that thought. But I do think that the study and the discussion thread that it generated tells us something valuable about how stock investing works and about the limitations (and in some cases even the dangers) of valuation-focused strategies.
The study results are surprising. I certainly think that much is fair to say. One community member argued at least somewhat persuasively that that should not really be the case. In the U.S. market, stocks prices have been increasing on average by 6.5 percent real every year for 150 years now. That impressive growth rate gives a strong upward push to stock prices. Yes, there are going to be years when prices go down hard too. But with prices going up on average by 6.5 percentage points per year, it is certainly fair to say that there are going to be more up years than down years and that the down years are going to be cancelled out by the up years once enough time passes. So perhaps it is wrong for us to expect price booms to bring on price crashes.
I don’t quite think that’s so. Yes, the steady upward push to prices will eventually overcome any downward trends. But the study defined “bubbles” as years in which prices increased by 100 percent. A doubling in prices obviously far exceeds the 6.5 percent average annual return that applies in the U.S. market. Even taking into consideration the strong and steady upward price movement that applies in general for the equity asset class, common sense tells us that a doubling in prices must be caused by irrational exuberance and should signal a price crash in the years to follow.
The study shows that our common sense is wrong. It is pointing us to a puzzle that we must resolve to have confidence that our understanding of how stock investing works is as strong as it needs to be for us to feel confident that we will be able to acquire the funds needed to retire at the stage in life when we hope to have access to them.
My first explanation of the surprising findings is that the study is not limited to examination of U.S. market data. The U.S. market is far more stable than most other markets and we have more data for it than we do for most other markets. I think that is a very good thing. But of course it is a reality that limits the upside for investors. It could be that some of the price doublings examined in this study were taking place in economies in which huge growth was possible because they were early-stage economies where big potential and big risk were both present. To the extent that that is so, the study does not tell investors focused on the U.S. market how their particular equity market works.
That said, I believe that the study does point to a phenomenon that applies even in the U.S. context. Doublings in U.S. stock prices are of course rare events. Given the maturity of our particular market, I would find a doubling of prices to be an alarming event despite the findings of this study. However, I also think that the study points to something real where it discourages the focus on bubbles that seems to dominate most discussions of the importance of taking valuations into account.
The P/E10 value was 8 in 1982. A doubling of prices would have put it at 15, the fair-value P/E10 value. Should investors have taken alarm as such a price change? Certainly not. A P/E10 of 8 (half of fair value) is as irrational as a P/E10 of 30 (two times fair value). We should want to avoid irrational depression as much as we should want to avoid irrational exuberance. A move from a P/E10 value of 8 to a P/E10 value of 15 is a strong move in the direction of sanity. Investors should not view such a doubling of stock prices as a crash signal.
But the study suggests more than that. The study suggests that even price booms that take valuations to dangerous levels do not often produce crashes within the five-year time-period examined. That’s an interesting finding even if not quite as shocking a one as it seems to be on first impression. There’s a reason why, when Robert Shiller made his famous 1996 prediction that investors who were heavily invested in stocks would come to regret it within 10 years, he looked forward 10 years into the future rather than just five years. 10-year predictions do not work. Even the crash that Shiller felt comfortable predicting in 1996 did not arrive until 2008, 12 years after he made it.
Overvaluation is caused by investor emotion. Investor emotion is an irrational phenomenon. Price jumps, even the crazy-sized price jumps examined in this study, often fuel MORE irrationality — crazy levels of overvaluation often signal even crazier levels of overvaluation rather than pullbacks.
That’s the way it works. A doubling of stock prices starting from a price level that is rational will produce a major pullback somewhere down the line. There is not a single exception to that rule in the history of the U.S. market. But there is no reason why even dramatic price gains starting from low price levels will produce pullbacks — price jumps starting from low price levels are sensible phenomena. And even price jumps taking the market to scary levels of overvaluation often do not generate crashes for 10 years or even a little bit more.
Valuations tell us a lot about how the u.s market works. But they do not tell us everything. Investors hoping to use an understanding of valuations to enhance their long-term investing results need to be as aware of the limitations of valuation analysis as much as they need to be aware of its power.
Rob’s bio is here.