The title of this weekly column is “Valuation-Informed indexing.” The purpose is to explore the model for understanding how stock investing works that is rooted in the research of Robert Shiller. Shiller showed that valuations affect long-term returns. If that is so, the market is not efficient, as those who follow the Buy-and-Hold model believe. Shiller was awarded a Nobel prize because his research potentially changes everything we once believed about how stock investing works. If the market is efficient, stock investing risk is a constant and market timing is a bad idea. If valuations affect long-term returns, stock investing risk varies depending on valuations and long-term market timing always works and indeed is always required for investors seeking to keep their risk profile constant over time.
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If it is true that valuations affect long-term returns, then it is possible to predict long-term returns. That’s an amazing advance. When it becomes possible for investors to predict their returns, most of the risk of stock investing disappears. There’s not much risk in investing in certificates of deposit, is there? The one big risk is that the inflation rate might be more than you anticipated, eating into your expected return. Other than that, you know what the outcome of your investment choice will be when you put your money down. So there is no risk. Stock investing would be like that in a world in which it was possible to predict long-term returns with precision.
Unfortunately, Shiller’s research does not permit us to predict returns with precision. It does not permit us to predict short-term returns at all. And even over long time-periods (time periods of ten years or longer), it does not permit precise return predictions. When the P/E10 value is 15 (the fair-value P/E10 figure)), there’s an 80 percent chance that the 10-year annualized real return will be greater than 2.6 percent. When the P/E10 value is 44 (the P/E10 value that applied at the top of the bubble), there’s an 80 percent chance that the 10-year annualized real return will be less than 1.9 percent. Both of those predictions cover a lot of territory. Even someone who has full confidence that Shiller is right cannot rule out the possibility that the 10-year return for an investment made when prices are where they were at the top of the bubble will be better than the 10-year return for an investment made at a time when stocks are priced at fair value. An investment made when prices are where they were at the top of the bubble might yield a 10-year return of 4.9 percent real (there’s a 1 in 20 chance of that happening in those circumstances) while an investment made at a time of fair prices might yield a 10-year return of a negative 0.39 percent real (agan, there’s a 1 in 20 chance)..
Still, the predictions offer extremely valuable information. The investor who buy stocks when they are priced as they were at the top of the bubble has little chance of doing better than the investor who buys stocks at a time when they are selling at fair prices. The most likely scenario is that he will be short by 6.7 percentage points of return. In a worst case scenario, he could be short by 19 points of return. Stocks are a lot more risky when they are selling at today’s prices than than they are when they are selling at fair prices.
I think that we all should be making use of the return predictions permitted by Shiller’s research findings in every strategic stock investment decision we make. But few investors are doing so. The return predictions that I advocate are extremely controversial. Buy-and-Holders do not believe that it is possible to predict stock returns effectively. They do not like hearing return predictions discussed at the investing discussion boards and blogs that they frequent. And 90 percent of today’s investors believe that the Buy-and-Hold model for understanding how stock investing works is at least more or less on the mark.
Even Shiller has come to doubt the value of long-term return predictions. He made a public prediction in 1996 that stock returns for the following 10 years would be negative. That one did not prove out. In interviews he has held in recent years, he has suggested that he does not believe in market timing. He has made comments suggesting that his personal experience of making predictions that did not prove out caused him to lose confidence in his ability to use the historical return data to make effective predictions.
I don’t agree with Shiller. I acknowledge that even long-term return predictions should be heavily caveated. But I believe that Shiller’s research is an exciting advance. And I don’t see that it has any practical value unless at least heavily caveated predictions are possible. Those of us who believe that Shiller merited his Nobel prize believe that valuations affect long-term returns. How does that help us as investors? It helps us by telling us when it is best to invest most of our money in stocks and when it is better to look for alternative investment options. If it is not possible to make any return predictions whatsoever, it is not possible to say when stocks offer a relatively appealing value proposition or a relatively unappealing value proposition. So, if we come to agree with Shiller’s current view that return predictions don’t work, we are giving up on all benefits that Shiller’s powerful research findings once promised.
I am not willing to go there. I am going to continue making long-term return predictions. Cautiously. Carefully. In heavily caveated language. But I am not willing to give up on the long-term stock prediction game altogether. The advance in our understanding of how stock investing works promised by Shiller’s Nobel-prize-winning research is too important.
Rob’s bio is here.