Do Compounding Returns On Pretend Stock Price Gains Produce Real Value?

Buy-and-Holders believe that stock price gains are caused by economic developments. That means that those gains have substance, that they have real and lasting value and can be relied on to finance a retirement.

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What Causes Stock Price Gains?

Valuation-Informed Indexers believe that some stock price gains are caused by economic developments but that gains in excess of the fair-price CAPE value are caused by irrational exuberance. Those gains are temporary and cannot be relied on.

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An argument could be made that the irrational exuberance gains don’t matter. Investors who enjoy such stock price gains only get to possess them for a limited time. Eventually those gains disappear into the mist. Investors who lower their stock allocation at times of crazy high prices don’t need to worry about missing out on bull-market gains because those gains are sooner or later going to disappear.

That argument does not tell the full story. High stock prices can remain in effect for a long time. The CAPE value went to crazy high levels in 1996 and has remained at such levels for most of the 24 years since. If the CAPE level falls to fair-price levels tomorrow, the investor who has been holding stocks for those 24 years still obtains the benefit of the higher return she has been earning compared to the return she would have been earning had she been invested in a non-stock asset class.

So the Buy-and-Holders are right! Investors should disdain market timing and stick with their high stock allocations regardless of how high stock prices go.

That argument does not quite tell the full story either, in my assessment.

Oversized Loss During Long Bull Markets

When stock prices crash, they do not crash only to fair-price levels. The crashes that come in the wake of long bull markets take stock prices down to levels just as crazy on the low side as they were crazy on the high side during the bull years. So the investor who stuck with a high stock allocation during the bull years suffers an oversized loss. Irrational exuberance is transformed into irrational depression. And the poor returns obtained during the bear years cancel out much of the performance advantage gained during the bull years. The investor who lowered his stock allocation when prices reached super high levels is able to buy stocks at good prices during the irrational depression days and can enjoy outsized stock price gains on those purchases for many years to come. The Buy-and-Holder does not have funds available to purchase more stocks when the asset class goes on sale; most of his assets are already tied up in stocks and of course he made his purchases at much higher prices.

Another issue is that investors who are open to the idea of moving a portion of their assets into non-stock investments can often obtain better-than-normal returns on those investments by looking for alternatives to stock when prices go out of control. Treasury Inflation-Protected Securities (TIPS) were paying a return of 4 percent real in January 2000. Stocks purchased at that time have offered a return of only 3.7 percent real during those years. That 4 percent return was an exceptional deal, to be sure. But I don’t think that it was a coincidence that an amazing return was being offered on a non-stock investment class at the time in U.S. history when irrational exuberance was at its height. It took that sort of return to attract investors to a non-stock asset class at that time. Investors who were unwilling to participate in the irrational exuberance were properly rewarded by the market for their contrary convictions.

A final factor to consider is that the investor who goes with a lower stock allocation at times when prices get out of hand endures less risk as a result of doing so. Buy-and-Holders often argue that, so long as prices have not crashed, they are better off having stuck with stocks. But of course they were taking on more risk by investing in an asset class that could crash at any moment even if that crash did not take place. If they were rational, they would insist on being compensated for taking on the extra risk. So a Buy-and-Holder needs to earn a return that more than matches the return earned by the Valuation-Informed Indexer just to be properly considered as being even with him.

All that said, there is a case to be made for sticking with a high stock allocation during years in which stock prices remain high for a long time. The edge is not nearly as great as investors have been led to believe by those promoting Buy-and-Hold strategies. But there can in at least some circumstances be an edge if prices remain high for as long as we have seen them remain high in recent years. This is one reason why it is a bad idea for valuation-informed investors to take extreme positions. It makes sense to go with a somewhat lower stock allocation when stock prices go sky high. It is generally not a good idea for the typical investor ever to exit the stock market entirely.

Rob’s bio is here.