Did How the Stock Market Works Change in 1996?

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Morningstar recently published a podcast in which they interviewed Wade Pfau, who co-authored research with me a number of years back showing the benefits of long-term market timing. The title of the podcast is — Wade Pfau: The 4 Percent Rule Is No Longer Safe. A transcript is set forth at the link.

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The Idea Of Using Market Valuations

Wade is asked at one point: “What about the idea of using market valuations as sort of a signal that it’s time to de-risk or does that seem too much life market timing to you?”

He states:

“Earlier in my career I was kind of more interested in that sort of approach. When we look at the historical data--and Robert Shiller has that historical data going back to 1871--it's kind of remarkable how well future market returns related to, like Shiller's CAPE ratio, the cyclically adjusted price/earnings ratio--that when it was above average, you lower your stock allocation and vice versa. And I think Shiller's research on that was just in the late 1990s. Once he kind of identified how well that relationship worked, that's pretty much the time it stopped working, because in the past 25 years or so, markets have been overvalued by that measure except for the brief period around the financial crisis in late 2008, going into 2009.

“So, somebody who followed those types of strategies would have had a lower stock allocation throughout and would have missed on what ended up, for example, this most recent bull market. So, I put less weight on that idea other than to use it to say at least--it's an argument in favor of at least stay the course. You don't necessarily want to do that sort of market-timing. But to the extent that you would have been better off going in that direction, that's a contrarian direction. That's saying, after market downturns there's a stronger case to be in the stock market. So, if you can use that to at least stay the course, that might help people overcome this notion of at least not converting into cash after a market downturn, which would be the opposite of what that valuation-based approach would be telling you to do.”

I of course believe that Wade got it right the first time. I believe that all investors should be engaging in market timing. Not the short-term variety, which never works because it is not possible to identify when turning points will take place. But the long-term variety, in which investors lower their stock allocation a bit at times of super high prices and increase them a bit at times of low prices in an effort to keep their risk profile roughly constant over time.

That form of timing always works, as Wade showed in the research he prepared with me. As he said at the time: “On a risk-adjusted basis, market timing strategies provide comparable returns as a 100 percent stocks Buy-and-Hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns.”

The Stock Market History

Wade’s description of the stock market history of the past 25 years is accurate. Market timing worked like a dream until 1996. Then prices skyrocketed in the late 1990s and have remained very high ever since, with the exception of a brief time-period immediately following the 2008 price crash. So is it true? Did Valuation-Informed Indexing “stop working” in 1996?

I don’t think we can say that today. We can say that it is highly surprising that prices have remained so high for so long. We can say that Buy-and-Hold has performed better in recent years than Valuation-Informed Indexers predicted it would. It is right and proper for critics of the Shiller-based strategy to note its failure to perform in its first looking-forward test (Shiller predicted in 1996 that investors who stuck with their high stock allocations would within 10 years come to regret doing so).

But it seems to me that those who claim that what has always worked in the stock market up until 1996 simply stopped doing so at that time need to address an important question. Why? Why did market timing stop working?

Buy-and-Hold and Valuation-Informed Indexing are rooted in different beliefs as to what causes stock price changes. Buy-and-Holders believe that investors are rational -- they push prices upward or downward in response to economic developments. Valuation-Informed Indexers believe that investors are highly emotional. They sometimes push prices up to crazy high levels and, since the market’s core job is to get prices right, it eventually pushes them back down again. Because we are dealing with a psychological phenomenon, there is no way to know when the price break will come. But, because the market must sooner or later get prices right, we can know with certainty that stock investing risk is much greater at times when prices are high.

I am not able to come up with an explanation as to why market timing would work for over 100 years and then suddenly stop working. If investors have been acting emotionally all these years (Shiller’s research shows that this is the case), how could that reality be reversed on a dime? This explanation of the last 25 years of stock market history seems far-fetched to me.

However, I do not find it too difficult to explain the last 25 years if I presume that Shiller is right that investing is a highly emotional business. Could it be that investors simply became even more emotional during this time-period than they have ever been before? The CAPE level reached levels in early 2000 far in excess of the highs that brought on the Great Depression. Perhaps when investor emotion gets so far out of whack, it takes longer for prices to return to earth. I cannot prove that that is so. But it does not seem like an entirely implausible hypothesis.

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