Book authors are told that they need an “elevator pitch,” a concise statement of the message of their book that will excite agents and publishers. My elevator pitch for Valuation Informed Indexing is — Shiller showed that market timing is price discipline and that changes everything.
The conventional line on Shiller is that he showed that valuations affect long-term returns. That’s just a non-provocative way of saying that market timing is price discipline. If valuations affect long-term returns, the risk of buying stocks is different at different valuation levels. If stock investing risk changes with changes in valuation levels, investors who want to keep their risk profile constant over time must adjust their stock allocation when valuations change. That’s market timing. If Shiller is right, market timing must work and market timing must benefit the investors who make use of it.
Q3 2019 hedge fund letters, conferences and more
If Shiller is right, practicing market timing is exercising price discipline. How could exercising price discipline ever be a bad thing?
If market timing is price discipline, the safe withdrawal rate is not always 4 percent but a number somewhere between 1.6 percent and 9.0 percent, depending on the valuation level that applies on the day the retirement begins.
If market timing is price discipline, stocks are not always the best investment choice. There is some price at which other investment classes (even super-safe investment classes like IBonds and Treasury Inflation-Protected Securities (TIPS) offer a stronger long-term value proposition than stocks.
If market timing is price discipline, stocks are not necessarily more risky than bonds. There are some price levels at which all of the long-term return possibilities for stocks are better than some of the long-term return possibilities for bonds.
If market timing is price discipline, stocks do not offer better returns than other asset classes solely because investors are being compensated for taking on more risk. In some cases, stock investors are being compensated because stocks are perceived as being risky even though the real risk of investing in stocks is small and in other cases stock investors are taking on large amounts of risk in exchange for a promise of only small returns.
If market timing is price discipline, investment advice that discourages market timing is going to hurt not only the investors to which it is directed but the entire economic system. A market in which price discipline is forsaken is a market that becomes dysfunctional and that eventually collapses. If market timing is price discipline, it is the heavy promotion of Buy-and-Hold strategies that causes price crashes.
If market timing is price discipline, it is the widespread belief in Buy-and-Hold (that is, in the idea that price discipline is not required when buying stocks) that causes economic crises. Trillions of dollars of consumer spending power disappear in price crashes. The economy obviously must contract dramatically when trillions of dollars of spending power disappear.
In short, if market timing is price discipline, investors are not entirely rational beings. If investors rationally pursued their self-interest, as the Buy-and-Holders believe, they would always practice price discipline. But Buy-and-Hold advocates not only fail to encourage investors to engage in market timing, they actively discourage the practice.
Shiller has described the intellectual leap from the finding that short-term price changes are unpredictable (University of Chicago Economics Professor Eugene Fama showed this in research published in the 1960s) to the Buy-and-Hold belief that the market sets prices properly as “one of the most remarkable errors in the history of economics.” I think that’s right. Market timing does not work in the short term because it is investor irrationality that causes both overpricing and underpricing and no one can say how long such irrationality will remain in place. But, for long-term market timing to not work, irrationality would need to be able to remain in place indefinitely. That’s a very different proposition. There has never in the history of the market been a time when mispricing remained in place indefinitely.
Which is another way of saying that there has never in the history of the market been a time when market timing (price discipline!) did not work. Price discipline/market timing is the key to long-term stock investing success.
Rob’s bio is here.
