Stocks

Does It Help to Add a Moving-Average Component to a Valuation-Informed Stock Investing Strategy?

Valuation-Informed Indexing #382

By Rob Bennett

A member of the Bogleheads Forum recently started a thread (“Using CAPE to Time Market?”) in which he expressed a view that the reason why using valuations alone to adjust one’s stock allocation is unsatisfying is because CAPE doesn’t predict short-term market moves. He sought feedback on whether it might be a good idea to combine the use of Shiller’s CAPE valuation metric (P/E10) with an examination of moving averages. The idea would be that the risks of using moving averages to time one’s allocation changes would be mitigated by making reference to the P/E10 level, which would signal to the investor times when severe price drops were more likely. The community member explained: “According to this strategy, I would follow a moving-average sell rule only when CAPE is high. At other times, I would refrain from using moving-average timing.”

I don’t think much of the idea.

I can see where the fellow is coming from. P/E10 works like a dream in predicting long-term returns. It’s been doing the job since 1870. But it can take a long time for those long-term predictions to come through. Shiller warned of high stock prices in 1996 and he is still warning of high stock prices in 2018. People don’t want to wait that long for a strategy to pay off. Investors want to see results in less than 22 years!

If Valuation-Informed Indexing worked more quickly, everyone would be a Valuation-Informed Indexer. This fellow is trying to make it work more quickly by adding a short-term timing element via the moving-average aspect of his proposed strategy.

I am a big believer in keeping things simple. Valuation-Informed Indexing works for a reason and it is important to keep that reason in mind at all times when implementing the strategy. The reason why today’s valuation level predicts the stock return that will apply in 10 years is that stock price changes are determined by shifts in investor emotion. It is of course that same reality that makes short-term timing so problematic. Emotions do not follow the dictates of reason. It is not possible to say when emotions are going to shift, So it is not possible to engage in short-term timing effectively.

The proposed strategy makes logical sense. The problem is that investor behavior often does not make logical sense. It is easy for logical thought to fail in the investing realm. The best example is what happened with stock prices in the late 1990s. Valuations were very high in 1996; stocks were priced to crash. But prices didn’t just stay steady or rise a little in 1997 and 1998 and 1999 — they soared! Why? The out-of-control investor emotions that made stocks dangerous in 1996 went even more out of control in 1997 and 1998 and 1999. Emotions are like that — they tend to extremes.

So it is not necessarily so that a P/E10 value that suggests that stock prices are ready for a big fall will produce the results expected for an investor who is following a moving-average timing strategy. The short-term direction of stock prices really is unknown. There is no way to game it. We have to accept the reality.

Valuation-Informed Indexing works because it has to work. The market has to eventually get prices right or it cannot continue to function. So, when prices are very high, we can be virtually certain that the long-term return is going to be less than normal. And, when prices are very low, we can be virtually certain that the long-term return is going to be more than normal. It is critical to keep things simple. Bet on what you know will happen and your bet will pay off. Reach too far and the outcome becomes less certain and the entire project is undermined.

Weather forecasts that are made close to the day for which the forecast is requested work. There are times when you want to know what the weather will be two days or three days or four days into the future. Those forecasts are more problematic. So it is with stock return forecasts. Predictions making a single assessment — is the risk associated with stocks greater when prices are high? — work. Predictions that try to do too much fail too often to do the investor much good. We can know when stocks offer a stronger or weaker long-term value proposition. But there is almost nothing we can say with confidence about when the events that will make the long-term value proposition strong or weak will take place.

Investors seeking to make good use of valuation-informed strategies need patience. What helps me is to avoid assessing my results by the standards used by most investors. It doesn’t matter how I am doing this year. It doesn’t even matter how I am doing this decade. What matters is my lifetime return. Am I setting myself up today for the investment performance that I want to see over the 60 years or so that I am likely to have money available to invest? That’s what matters.

The historical return data shows that works best over an investor’s lifetime are valuation-informed strategies that don’t aim to do too much. My goal is to keep my risk profile roughly constant over time. That much can be done. Going too much beyond a simple goal like that only gets the valuation-informed investor in trouble.

Rob’s bio is here.