Valuation-Informed Indexing #377
By Rob Bennett
Say that you and a friend were having a discussion about how the stock market works in 1996. Robert Shiller had just delivered his testimony to the Federal Reserve in which he argued that investors who stuck with their high stock allocations would come to regret it within 10 years. You found that claim convincing; valuations were just too high. But your friend argued that it was a silly assertion — timing doesn’t work, so how could Shiller know whether stocks were still a good bet or not?
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This is the debate between Buy-and-Holders and Valuation-Informed Indexers. This is the debate that has been going on since the first stock market opened for business. If the market is rational, big jumps in prices are a wonderful thing. They leave every investor alive better off. What’s not to like? But if valuation levels signify something important, big jumps in prices are a warning sign that stocks are about to let investors down in a big way. Price jumps are a negative, not a positive.
This difference in perspective affects every stock strategy question there is. Where you come down on the question of whether rising stock prices are a good thing or a bad thing determines what you think about risk management and what you think about asset allocation and what you think about retirement planning. But it determines what you think about safe withdrawal rates in an even more extensive way than it determines what you think about any other stock strategy question. So I think it would be fair to say that exploring the safe withdrawal rate question in depth is the best way to learn how the stock market works in general.
Shiller advanced his 10-year warning in 1996 because stock valuations were already at levels that in the past had always caused an economic crisis -- the P/E10 level was in the mid-20s. Shiller accepts that short-term market timing doesn’t work. This is why he limited his warning to predictions of how stocks would be performing 10 years out. He was avoiding the question that most investors want answered -- how are stocks going to do over the next year or two or three? Instead, he was answering the far more important question that his research addresses -- how are stocks going to do over the next 10 years and over the next 15 years and over the next 20 years? The stock valuation levels that applied at the time told us that they were going to do poorly.
Say that Shiller has been asked what he thought of stocks as an investment choice at the time and he had said “not much.” Many investors would have concluded in the following years that Shiller didn’t know what he was talking about. From October 1996 (when Shiller gave his testimony) through December 1999, stock prices doubled. It turned out that stocks offered an AMAZING value proposition in October 1996.
From October 1996 through October 2006, the annualized return on U.S. stocks was 6 percent real. That's only slightly less than the long-term average return of 6.5 percent real, which is very good indeed. Still, it’s something less than amazing. An investor who lowered his stock allocation in October 1996 in response to Shiller’s comments would not be happy that he did so but he would not be entirely enraged that he did so in the event that he moved the money into the Treasury-Inflation Protected Securities (TIPS) or IBonds that were offering a 4 percent real return during a good part of that time-period.
Go two more years out (to October 2008) and the annualized return drops to 1.7 percent real. That return would cause many investors to celebrate Shiller rather than to catigate him.
In the real world, most investors ignored Shiller. We couldn’t have seen the sorts of price increases that we saw in the years that followed his testimony had most investors taken his warning seriously. Were they right to ignore him? Most Buy-and-Holders would say they were. They would point to that 100 percent return we saw in the following three years as evidence of how dangerous it is to use valuations to predict future returns. Or, if they were inclined to be a bit more fair to Shiller and to assess the value of his prediction using the time length for it that he specified, they would note that even 10 years after the prediction was advanced stocks were doing just fine and that Shiller’s claim that stock investors would come to regret their choice by that time had missed the mark.
I have a different take. I am not impressed even a tiny bit with the 100 percent return we saw in the three years following the prediction. To me, that crazy return supports Shiller’s core belief that it is investor emotion rather than economic realities that drive changes in stock prices. The emotion that took stocks to the crazy prices that applied in 1996 took them to even crazier prices in 1999. I don’t want to invest in stocks when the price is being propped up by crazy levels of emotion. So that crazy 100 percent price increase signals to me that Shiller’s warning was rooted in something real that had not yet evidenced itself in a big price drop.
Which of course it did by October 2008. In October 2006 -- the 10-year mark for Shiller’s 10-year prediction -- the out-of-control emotionalism of which he was warning was beginning to evidence itself but only in modest ways. But by October 2008, we were seeing just how dangerous stocks become when they rise to the price levels that applied in 1996 (and that apply today). I care much more about how stocks perform in the long run than I do about how they perform in the short term or in the medium term. The fact that Shiller was able to see what happened in 2008 so much sooner and so much clearer than just about anyone else tells me that I should be paying close attention to the rest of what he says about how stock investing works.
The safe withdrawal rate concept is a long-term concept. It’s not possible to tell someone how realistic their retirement plan is by seeing how it performs in one year or two years or three years. And it is not helpful to tell them that it will take 20 years for them to know whether the plan is going to work or not. Aspiring retirees need to know how plans that stretch far into the future are going to work but need that information on the day the retirement begins. They need long-term guidance, not short-term guidance. But they need that guidance provided in the short-term.
The magic of Shiller’s research showing that today’s P/E10 level offers highly accurate predictions of how stocks will perform 10 and 15 and 20 years out provides just that. The safe withdrawal rate at the time Shiller offered his prediction was 3.1 percent. That’s probably a better indicator of the value proposition offered by stocks at the time than Shiller’s helpful but flawed prediction. The 3.1 percent number is not so awful as to overstate the dangers of stocks when they are selling at those price levels. But it is low enough given the average long-term return of 6.5 percent to suggest that stocks were a far less appealing option than they are in ordinary circumstances. That simple number told the story better than Shiller’s carefully prepared testimony!
Rob’s bio is here.