The Hill-and-Valley Pattern of Stock Prices Is Strong Evidence That Shiller Is Right

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I believe that engaging in market timing is essential to achieving long-term stock investing success. That belief follows from Robert Shiller’s Nobel-prize-winning research finding that valuations affect long-term returns. If valuations affect long-term returns, then irrational exuberance is a real thing and stocks are more risky at times when the level of irrational exuberance is high than they are when the level of irrational exuberance is low. So the investor seeking to keep her risk profile roughly stable over time must engage in market timing to have any hope of doing so. Not only does market timing always work, it is always required.

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Market Timing Always Works

There is a huge amount of resistance in this field to the idea that market timing always works and is always required. Before Shiller came along, the dominant belief among academics was that the market is efficient and that investors are 100 percent rational in the choices they make. If that were so, irrational exuberance would not exist and market timing would not work. So today there are two schools of thought as to how stock investing works, each starting from fundamentally different core premises.

How can we know which model is legitimate?

The usual way of analyzing the question is to determine the strength of the correlation between today’s CAPE value and the return earned on stocks over the next 10 or 15 or 20 years. If the market is efficient, there should not be any correlation. If irrational exuberance is a real thing, the correlation should be strong. Long-term stock returns should be highly predictable.

The correlation is quite strong, strong enough to persuade me that Shiller’s model for understanding how stock investing works is the right one. But the correlation is not perfect for two reasons.

One, it can take a good bit of time for stock prices to return to fair-value levels. Short-term timing really doesn’t work and any assessment of the correlation between valuation levels and returns produced is based on a mix of short-term and long-term results. The correlation is always weaker than it would be if it were possible to isolate long-term returns.

Two, stock returns play out in cycles in which long bull markets are followed by long bear markets. Prices go steadily up for a long stretch of time (with occasional, temporary price drops mixed in) and then steadily down for a long stretch of time. It can take 40 years or even a bit longer for a bull/bear cycle to come to completion. That means that we only have four bull/bear cycles to look at (we have good records of stock prices going back to 1870). It’s hard to have great confidence in a correlation that has held true for only four bull/bear cycles. The case for Shillers’ model will be stronger when more data is in the books (presuming that his model really is the better model).

The Correlation Between Valuations And Long-Term Returns

There has been a good bit of argument over the years between those who find the correlation between valuations and long-term returns to be very strong and those who find it to be not be terribly strong. It has been hard to reach a consensus on the matter because the correlation is less strong in recent decades than it was in all the years of stock market history available for review from 2006 backwards. Were we to see a price crash within the next year or two or three, the case for the Shiller model would be strengthened. But in the event that the Shiller model is not legitimate, there is no reason to believe that a price crash is more likely today than it would be at any other time. Price crashes are always equally likely in a world in which the market is efficient.

I believe that a factor that is not given sufficient attention is the way in which prices have always headed upward for a long stretch of time and then downward for a long stretch of time. If the market were efficient, prices would play out in the form of a random walk. But that is not at all what we see when we look at the historical return data. It’s not just that the data shows a strong correlation between valuations and long-term returns. The pattern in which prices play out supports Shiller’s idea that it is shifts in investor emotion that drive stock price changes rather than economic developments. Investor emotions are slow to change. Once the idea gets locked in that prices will he headed upward, irrational exuberance rules the day for a large number of days Then, once the idea gets locked in that prices will be headed downward, irrational depression rules the day,

Stock prices do not reflect the current day’s economic realities. They reflect the stubbornly held emotions of investors, positive for a long stretch of time and then negative for a long stretch of time following a price drop painful enough to break the optimistic outlook. The fact that prices have always played out in this manner is strong evidence that Shiller is right, evidence every bit as strong as the more frequently referenced evidence that today’s valuation level tells us much about the stock return that will apply for the next 10 and 15 and 20 years.

Rob’s bio is here.

Stock Investing Claims That Are Not Falsifiable Are Not Scientific

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I am not a Buy-and-Holder. I like to think of myself as the foremost critic of Buy-and-Hold alive on the planet today. It is my view that Buy-and-Hold is a pure Get Rich Quick approach because Buy-and-Holders disdain market timing, which is the only means available to us of keeping irrational exuberance under control.

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Buy-And-Hold Porports To Be A Research-Based Strategy

However, there is one aspect of the Buy-and-Hold concept that I absolutely love. Buy-and-Hold at least purports to be a research-based strategy. I don’t believe that it truly is that because the Buy-and-Holders have never updated their strategy to reflect Robert Shiller’s Nobel-prize-winning research findings. But I do think that the Buy-and-Holders were sincere about wanting to craft an investment strategy rooted in science and I believe that in the long term it will be their legacy that they planted in investors’ heads the idea that an investment strategy should be science-based.

If only the Buy-and-Holders had stuck to their core belief!

A key principle of science is that scientific claims must be falsifiable. Most Buy-and-Hold claims are not. That’s why I no longer think of Buy-and-Hold as a science-based approach.

Does market timing work? The Buy-and-Holders say it does not. Say that someone disagrees with that claim? How would he go about disproving it?

He wouldn’t be able to shoot holes in the research showing that market timing does not work. There is no such research! People think there is. Buy-and-Holders make the claim so often that people assume that there must be some research supporting it. But no. There is research showing that short-term timing (changing your stock allocation with the expectation that you will see a benefit for doing so within a year or so) does not work. But showing that short-term timing does not work is not at all the same thing as showing that timing in general does not work. There has never been any peer-reviewed research published showing that market timing in general does not work.

Valuations Affect Long-Term Returns

So what can someone trying to make the case for market timing do? In theory, he could show that market timing has always worked. Shiller did that. He showed that valuations affect long-term returns. If valuations affect long-term returns, the long-term value proposition for stocks has to be stronger at times of lower valuations and so investing more heavily in stocks at such times must produce a payoff. Wade Pfau and I produced research looking at this question more directly and of course our research showed that investors who engage in market timing lower their risk and increase their long-term return by doing so.

The response of Buy-and-Holders has been to say: “Oh, but you never know about such things! It could be that everything will be different on a going-forward basis.” In fact, I wrote an article here a few weeks ago in which Wade himself said something along these lines. He said that he used to believe in market timing but that, given how stocks have performed from 1996 forward, he no longer does. Shiller famously predicted in 1996 that investors who stuck with their high stock allocations would live to regret it within 10 years. But the reality has been that stock prices have remained high for the 24 years since Shiller advanced his prediction (with the exception of a few months at the end of 2008 and at the beginning of 2009).

It could be that everything changed in 1996. There’s no way to prove otherwise. If stock prices crash hard within the next few years, I doubt that anyone will be saying that the rules of stock investing changed in 1996. If we experience the horrors of a price crash and the economic collapse that would likely accompany it, everyone in the field will be cracking his copy of Irrational Exuberance to figure out where he got on the wrong track in his understanding of how stock investing works. But the damage will have been done at that point. The time at which we need to take Shiller’s research findings into consideration is now. And, as of today, the popular idea is that the basics of how stock investing works changed in 1996.

Which is a non-falsifiable claim. Say that you do not believe that the basics changed in 1996 and the Buy-and-Holders will point to today’s high prices as evidence that you are in the wrong. Had you followed Shiller’s advice in 1996, you would have “missed out” in the gains experienced over the past 24 years (gains that are to a large extent the product of irrational exuberance, according to Shiller’s understanding of the subject). The only thing that could ever prove to a Buy-and-Holder that his strategy is not sound would be a devastating price crash that would render the question of what works in stock investing moot (since the gains produced by irrational exuberance would at that point be gone).

Scientific claims have to be falsifiable. The Buy-and-Hold claim that market timing does not work is not falsifiable. It is a claim that sounds good for so long as prices remain high and then becomes irrelevant for practical purposes when they crash.

Rob’s bio is here.

Conditions Were Perfect for Widespread Cognitive Dissonance When Shiller Published His Revolutionary Research Findings

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There are two schools of academic thought as to how stock investing works, Buy-and-Hold (which everybody knows about) and Valuation-Informed Indexing (the school of thought rooted in the research of Robert Shiller). Few investors even know that Buy-and-Hold has even been challenged. For most of us, the idea that market timing is a bad idea is as well-established as the idea that the earth is not flat but round. The idea that market timing is the key to long-term investing success (the core principle of Valuation-Informed Indexing) is an absurdity.

How did that come to be the reality? Shiller was awarded a Nobel prize for his research showing that valuations affect long-term returns. If that is so, then stocks are obviously more risky when valuations are high and the investor who wants to keep his risk profile roughly constant over time has no option but to practice market timing. It would be understandable if there were differences of opinion on the question of whether market timing is a good thing or not. But it is an exceedingly strange reality that most investors are not even aware that there is a good bit of solid research showing that long-term market timing always works.

I believe that the cause of the confusion is that the difference between the two models is so stark. The term that academics use to describe the shift from Buy-and-Hold to Valuation-Informed Indexing is “paradigm change.” If it is true that valuations affect long-term returns, then nothing that we once believed about how stock investing works is valid. Just for starters, we cannot trust our portfolio statement to reveal the true value of our stock holdings. If overvaluation is the product of irrational exuberance rather than the product of a rational assessment of economic realities, we all need to divide the number on our portfolio statement by two to know the true value of our stock holdings at times when stocks are priced as they are today.

I am often asked how this situation came to be. Was there a great conspiracy in which everyone who works in the investment advice field agreed to keep discussion of the realities from us?

I am generally skeptical of conspiracy theories. I think that a better explanation of the strange reality is that our confusion over how stock investing works is the result of one of the most widespread cases of cognitive dissonance ever experienced. Shiller published his research and it attracted a good bit of attention. But most of us continued thinking about stock investing in the same way in which we did before he came along all the same. Shiller’s message did not implant itself into our brains because our filters found it too radical for serious consideration.

Cognitive dissonance has been described as “the discomfort felt by a person who holds conflicting ideas, beliefs or values at the same time.” It’s not possible for the same person to believe in both the research of Eugene Fama (in which the Buy-and-Hold strategy is rooted) and of Robert Shiller. A stock portfolio cannot be worth both $200,000 and $100,000 at the same time. And it is of course not possible to form opinions about any investment strategy question without first determining the value of one’s stock holdings. Those who believe in Buy-and-Hold walk one path and those who believe in Valuation-Informed Indexing walk another.

The unfortunate thing is that we need to hear the two sides talking to each other to learn which has the better case. But is it possible for someone who believes in Fama’s research to engage in respectful and friendly discussions with someone who believes in Shiller’s research? It is possible. I have been engaged in such discussions on numerous occasions. But respectful and friendly discussions between Buy-and-Holders and Valuation-Informed Indexers are not the norm. Tell someone that his stock portfolio is worth only 50 percent of the amount that he sincerely thinks it is worth and the usual response you are going to see is consternation. Shiller’s research findings are startling.

The conditions were perfect for widespread cognitive dissonance when Shiller published his first research challenging the Buy-and-Hold dogmas in 1981. One, Buy-and-Hold had already become the dominant academic theory for explaining how stock investing works at that time. Two, the question of how stock investing works is obviously not only a matter of academic study; the practical aspects of the question are of great concern. By 1981, there were many people making a living based on their expertise re the Buy-and-Hold Model. Discredit the model and you would discredit these people’s livelihoods. There were many people in positions of influence who had strong personal reasons for feeling skepticism about Shiller’s findings.

Three, stock prices were at rock-bottom lows in 1981. That meant that it was easy to dismiss Shiller’s concern over the effects of overvaluation. Those who were not inclined to replace the Buy-and-Hold Model could tell themselves that there was little chance that stocks would ever again be priced at fair-market levels much less at levels much greater than that. So there was little sense of urgency re the project of incorporation of Shiller’s findings into the widely accepted understanding of how stock investing works. And, by the time prices reached dangerous levels in the mid-1990s, most in the field had already been generally ignoring Shiller’s findings for over a decade and felt embarrassment over the idea of acknowledging at that late date that there was new research that cast doubt about many of the strategies that they had been advocating for years.

Shiller’s research constitutes a major advance. We know today many important things about how stock investing works that we did not know in earlier times. But for practical purposes we do not know those things. Few of us have yet been able to integrate Shiller’s research findings into our thinking about this important subject matter.

Rob’s bio is here.

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