I have the greatest possible respect for Jeremy Grantham. He has written extensively about the importance of paying attention to stock valuations in an intelligent and illuminating way.
So a Yahoo Finance article (The Stock Market Has Been in a New Price Regime for 20 Years) quoting Grantham as saying that today’s high CAPE ratio may not be as scary as it seems to be when compared to the CAPE ratios that have been the norm in the past got my attention. The article was published in 2017 but it only recently came to my attention when a critic of mine linked to it on my blog. The article quotes Grantham as saying that: ““For a long and painful 20 years – for someone betting on a steady, unchanging world order – the P/E ratio stayed high by 1935-1995 standards. It still oscillated the same as before, but was now around a much higher mean, 65% to 70% higher! This is not a trivial difference to investors, and 20 years is long enough to test the apocryphal but suitable Keynesian quote that the market can stay irrational longer than the investor can stay solvent.”
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Grantham explains that: ““After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months. So, we have actually spent all of six months cumulatively below trend in the last 25 years! The behavior of the S&P 500 in 2002 might have been whispering in my ear, but surely this is now a shout? The market has been acting as if it is oscillating normally enough but around a much higher average P/E.”
He adds that: “If we have a bear market soon, even a severe one, will it recover to the new normal of 23x or the old normal of 15x? I believe the former. Let me remind you that that new 20-year era of higher prices was very severely stress-tested by the 50% decline from the 2000 Tech Bubble and the 50% decline in 2008-2009, perhaps the biggest foul-up of the financial system in modern times. Neither spectacular event was enough, apparently, to jolt the price trend back to its former lower level.”
I have been writing about valuation-informed stock investing strategies for 17 years. I am a big-time believer. I often ask myself before I go to sleep at night whether there is some aspect of the question that I am missing, if it could be that it is the Buy-and-Holders who are really on the right track and that I have devoted many years of my life to a loser issue. On consideration of all issues but one, such questioning only causes me to come to possess even greater confidence in the Valuation-Informed Indexing concept. Consideration of the point being made by Grantham is the one thing that shakes my confidence. There has never before in history been a time when stock prices have remained this high this long. Has there been some fundamental change in how the market operates that investors who believe in the importance of valuations have not taken into account?
We can’t rule it out. There is just not enough stock market history available to us to permit us to rule out that possibility. So I believe that investors who are drawn to valuation-informed strategies need to take Grantham’s argument seriously. I am not personally persuaded that the fair-value CAPE ratio is today higher than it was in the past. But I do not feel at all comfortable ruling out the possibility. It might be so. And, if it might be so, investors considering changing their stock allocation because of high valuations need to pause and reflect on the possibility that it really might be so before taking actions that could hurt them down the line.
After doing a little research, I learned that Grantham has not turned quite as negative re valuation-informed strategies as the Yahoo Finance article suggests. I will explore the nuances of Grantham’s take on these matters in next week’s article. For now, though, I will offer my personal take as to why the fact that stock prices have remained high for longer than they ever have before does not mean that investors can stop being concerned about high CAPE values.
I write about stock investing primarily on internet discussion boards. The internet discussion board is an intensely personal communications medium. When people get angry, they are often unrestrained in their expressions of anger; those expressing minority viewpoints see words directed at them that they would never see if they were advancing those words in books or in speeches or in magazine articles. Today’s investor is an intensely emotional investor. I have seen levels of emotion expressed in stock investing discussions that I have never seen in the most hot-button of political discussions. The level of emotion evidenced by a significant percentage of today’s Buy-and-Hold investors (and tolerated by all but a few of today’s Buy-and-Hold investors) is off-the-charts scary.
That tells me that Shiller is right, that valuations really are a big deal. The thing that makes this puzzle hard to solve is that, if Shiller is right, investors should be more emotional today than they have been at any earlier point in U.S. stock market history. And they are! It’s true that valuations have remained high for a longer time than ever before. But is that because the market has changed in some fundamental way, as the Yahoo Finance article suggests? Or is it because today’s investors are more emotional than were the investors of any earlier time and are thus less willing to permit stock prices to drop to their fair-value levels? If that’s the case, the fact that prices have remained high for so long a time should cause us to be even more alarmed, not less so.
I remain alarmed. But I am of course a highly biased observer of these matters. All investors should take Grantham’s words seriously. He is a serious person making a serious point (and, while the Yahoo Finance article did not describe his views with complete accuracy, they did quote him accurately and the quotes above should be disconcerting to all investors who follow valuation-informed strategies). I don’t think that any of us know with absolute certainty what has been going on with stock valuations over the past two decades.
Rob’s bio is here.