Robert Shiller warned investors in 1996 that valuations were so high that those going with high stock allocations would in time come to regret that choice. Most Buy-and-Holders believe that he has been proven wrong. But is that really so?
Stock prices have increased by 309 percent from July 1996 (when Shiller issued his warning) through today. So an investment of $100,000 would have grown to over $400,000. But stocks are today priced at over two times fair value. If overvaluation is the product of irrational exuberance not possessing lasting economic significance, that $400,000 could be reduced to $200,000 in the next year or two or three. IBonds and Treasury Inflation-Protected Securities (TIPS) were available in the years following Shiller’s warning that paid long-term returns of 4 percent real that could be locked in for up to 30 years. Investors who were prompted by Shiller’s warning to lock in those juicy returns will end up ahead of their Buy-and-Hold friends in the event that stock prices fall by 50 percent and they would have gotten ahead by investing in far less risky asset classes. They would have obtained higher returns while taking on reduced risk, a good deal all around.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
I have never run into a Buy-and-Holder who looks at things that way. I understand. They look at the numbers on their portfolio statement. They accept those numbers as hard and real and lasting. They do the math, determine that they are ahead of where they would have been had they paid heed to Shiller’s warning and consider the case closed. It’s not an entirely unreasonable way of looking at things.
I don’t think it is an entirely reasonable way of looking at things either, however. The problem is that the logic is circular. Buy-and-Hold is rooted in a belief that the market is efficient, that investors act in a rational manner to achieve their best interests. If that were so, the numbers on portfolio statements would be meaningful and lasting and reflective of economic realities. If that were so, Buy-and-Hold would be the ideal strategy.
But doesn’t it beg the question to assume that all this is so?
Shiller’s belief is that it is not so. Shiller says that investors do NOT pursue their self-interest when making investment choices. He says that investors are human and should be presumed to be guilty of all of the self-destructive emotional choices that humans are guilty of when engaged in any pursuit other than stock investing. He says that the numbers on portfolio statements that are caused by overvaluation do not reflect economic realities but irrational exuberance. He says that irrational exuberance always disappears in time, that the numbers we see on our portfolio statements today cannot be counted on to reflect lasting realities.
To say “I have been proven right to ignore Shiller because the numbers look good for me today” is not a compelling argument if the overvaluation warned of by Shiller remains in effect (and the P/E10 value today is a good bit higher than what it was in 1996). It would be fair to say that Shiller’s warning has not been proven correct yet (and it certainly was not proven correct in the time-frame specified by Shiller when he made the prediction -- Shiller said that he thought that those who invested heavily in stocks in 1996 would regret the decision within 10 years). But, if Shiller is right in his core belief about how stock investing works (that prices are set primarily by investor emotion rather than by economic realities), we should still expect that his warning will eventually be proven to have been good advice.
The biggest problem that I face in persuading investors of the dangers of Buy-and-Hold strategies is the long delay in the feedback mechanism by which investors assess whether their strategies have been proven successful or not. Buy-and-Hold strategies appear to be performing acceptably today because valuations remain at sky-high levels. Those of us who believe that Shiller is right believe that today’s stock price numbers need to be adjusted for valuations before a realistic assessment can be made as to whether those numbers indicate success for the investor following a Buy-and-Hold strategy. But the Buy-and-Holders see no need for such adjustments! Looking at things from their perspective, the success of their strategy is self-evident. I think it would be fair to say that Buy-and-Holders and Valuation-Informed Indexers speak different languages.
This is why I am such a strong believer in the merit of using peer-reviewed research to guide one’s investment choices. Shiller showed that stock prices do not play out in the pattern of a random walk, as Buy-and-Holders believe, but in a hill-and-valley pattern that takes between 35 years and 40 years to complete. Since most investing lifetimes extend for perhaps 60 years (from age 25 to age 65), most of us only witness one full bull/bear cycle and a portion of a second. That’s not enough personal experience to help us understand the dangers of bull markets, that they inevitably bring on devastating bear markets. It is only by looking at peer-reviewed research which examines the entire historical record that we can come to appreciate the ephemeral nature of stock prices that rise too high above the long-term average return.
I think that Shiller was right in the warning he advanced about high stock prices in 1996. I think that my Buy-and-Hold friends are mistaken to think that the danger has passed because high stock prices have not yet brought on the crash that will do lasting damage to their retirement hopes. They see things differently. They draw comfort from the numbers they see on their portfolio statements today and think that I am crazy to insist that Shiller was saying something important.
I am biased. I don’t say different. But it is my strongly held view that they are biased too. The two schools of thought begin from different core beliefs re the cause of stock price changes. We pursue logic chains beginning at those very different starting points to very different ending points. One school of thought is on the right track and one is on the wrong track. Only the passage of time will tell which point of view will ultimately prevail.
Rob’s bio is here.