I wrote last week about an article in Yahoo Finance from 2017 that suggested that Jeremy Grantham has come to doubt whether the CAPE ratio is as good an indicator of future stock performance as it has been made out to be by people who promote valuation-informed investing strategies. The article addresses what I view as the greatest weakness of the Valuation-Informed Indexing strategy — stock prices have remained at extremely high levels for over 20 years, far longer than has ever been the case in earlier U.S. stock market history. Could it be that the market has changed in some fundamental way such that the strategy will not work on a going-forward basis?
Grantham almost says that. He says: “We have actually spent all of six months cumulatively below trend in the last 25 years!…The market has been acting as if it is oscillating normally enough but around a much higher average P/E.”
That is a compelling statement. Grantham possesses a strong bias in favor of valuation-informed strategies. So for him to say that is a sure signal that something has changed that casts at least some doubt on the entire Valuation-Informed Indexing project. I remain a believer. But I intend to make it a point to tell investors thinking of making the switch from Buy-and-Hold to carefully consider Grantham’s comments and the remarkable realities that prompted him to put them forward.
All that said, a little research shows that the Yahoo Finance article did not describe Grantham’s views in all their nuance.
The quotes in the article are accurate. Grantham really does believe that stock valuations may not return to normal levels as soon as a student of the history of U.S. valuation levels would expect them to. He truly does believe that this time will be somewhat different. But he does not believe that the market now operates pursuant to entirely different rules. He believes that high stock prices have become more “sticky” than they have ever been in the past and that the old valuation levels will reassert themselves in time. In short, valuation-informed strategies will continue to work but probably not on the same time schedule as applied in the past.
Grantham objected to reports suggesting “that I believe high prices are here permanently and that I also believe regression to the mean has ended. This is, of course, inaccurate, as readers of my quarterly letters know. I have suggested that although mean reversion in margins and price earnings ratios is still probable, the speed of regression has slowed way down and become sticky. This slowdown is because nearly all of the factors causing it are themselves unlikely to change fast. These include Fed policy including moral hazard, lower interest rates, an aging population, slower growth, and productivity; and increased political and monopoly power for corporations. Because of this stickiness, I have suggested that regression of P/Es and profit share will take 20 years as opposed to the 7 years...that is more typical of the period 1900-1997 and that even then those measures will have only regressed back two-thirds of the way to the old normals… We should be braced for a long-drawn-out and painful flight path back toward the old ratios we know.”
Grantham is not saying that a CAPE value of 23 is the new normal. He is saying that the market has acted as if 23 is the new normal for over 20 years now and that it may continue to act as if 23 is the new normal for some time to come. But he is also saying that a CAPE value of 16 remains the true normal and that we will be getting there eventually. And, most importantly, he is saying that the long delay that we have experienced in getting back to truly normal prices has not been a boon to investors. It has hurt us. We would all be better off if insanely high prices had not become so sticky. He observes that: “What was quite surprising to me in this work, though, was how damaging even this reduced regression rate would be to the imputed returns of the S&P 500: 2.7% real per year for 20 years, a rate bound to break the hearts of many corporate and public pension fund officers.”
The difference between Buy-and-Hold and Valuation-Informed Indexing is fundamental. If Buy-and-Hold posits that stock prices are the product of investor rationality; we are all doing our best to pursue our self-interest and thus the market price reflects something real and solid and lasting. Valuation-Informed Indexing posits that stock prices are often largely the product of irrational exuberance and thus the market price often cannot be trusted to do a good job of revealing to investors the true and lasting value of their accumulated life savings.
Mispricing is a negative. When stock prices rise to unjustified high levels, we all are hurt. Businesses take on workers that they cannot afford, consumers make purchases that they otherwise would not, policymakers make choices that do not make sense given the true economic realities and not the pretend ones suggested by the fake good times financed by a temporary irrational exuberance.
Grantham has engaged in some speculation as to the factors that have made high stock prices so sticky. I will offer some thoughts re those speculations in next week’s article.. I of course acknowledge the greater stickiness of high prices that has applied for 20-plus years now. I see it as a bad thing because I believe that it is the product of investor emotion rather than of a reasoned assessment of the economic realities. I don’t think that the greater stickiness should offer comfort to Buy-and-Holders. I believe that it should cause them alarm that we are as a nation of investors hurting ourselves even more than Shiller warned us we were back in the days when he predicted that investors who were continuing with high stock allocations in 1996 would come to regret doing so within ten years.
Rob’s bio is here.