I was on a walk with a friend the other day and he asked me what is the strongest argument that I can make in opposition to Valuation-Informed Indexing. The first thing that came to mind is that the first true research-based strategy has not performed well in recent years.
Shiller’s Warning
In 1996, Shiller published a paper warning that investors who failed to lower their stock allocations in response to the crazy valuation levels of that time would live to regret it within 10 years. We did not see a price crash for 12 years. So Shiller was a bit off. He had come up with the 10-year figure by looking at how long it had taken earlier bull markets to collapse.
But it wasn’t only that he was off by two years. Stock prices were back at high levels again by late 2009 and they have remained there ever since. So Buy-and-Hold was a successful strategy for the entire time-period from 1996 forward.
The Buy-and-Holders suffered temporary losses in 2008. But stocks generally offer much higher returns than do the asset classes that Valuation-Informed Indexers would have moved to in 1996. Investors who followed the Buy-and-Hold line were rewarded for doing so. For a long stretch of years.
But why? It’s important to know why.
Some (Wade Pfau in his post-flip days is in this camp) have speculated that something in how the stock market works changed in 1996, that Valuation-Informed Indexing was the superior strategy until then but no longer is. There’s of course no way to disprove such a claim. It could be.
But the advocates of this theory do not specify what it is that changed, they just say that they believe that something did. Believing that is not taking a research-based approach to stock investing, as the Buy-and-Holders recommended in their early years. It’s giving up on the idea of using the historical data as a guide to ignore the data when it tells you something that you don’t want to hear.
Market Timing Has Always Worked
I cannot promise you that nothing has changed in how the stock market works. All that I can say is that I do not personally feel comfortable investing in a way that ignores how stocks have always performed in the past. Market timing has always worked in the past and I think that the most sensible bet is that it will continue to work in the future.
There’s no question that market timing has not worked as well in the post-1996 time-period as it did in all the years prior to 1996. I see that reality as being a little scary for the Buy-and-Holders.
There’s no magic in the long-term average return of 6.5 percent real. That’s the number that the level of productivity generated by the U.S economy has supported from 1870 forward. If our economy is more productive in the future, the future number will be higher; and, if our economy is less productive, the future number will be lower.
I think the safest bet is to assume that the going-forward number will be not too far off from the number that applied for the entire history of the market – 6.5 percent. Say that that indeed turns out to be so. If that turns out to be so, then we are likely to see a worse return sequence in coming days than anything that we have seen in the past.
For 6.5 percent to remain the average return, any time-periods in which returns were better than that (the time-period from 1996 is such a time-period) have to be matched with time-periods in which returns are worse than 6.5 percent.
Predictions Of Stock Returns
I am not predicting that. I believe that it is not possible to be precise with one’s predictions of stock returns. We are going by what was happened in the past and there is not enough historical data available to us for us to be confident that we will not see something in the future that differs from anything that we have seen in the past.
Of course that is what happened in the post-1996 time-period. It is certainly good for investors to be aware that looking at what happened in the past does not tell us everything there is to know about what will happen in the future. And Shiller did note as a caveat in his 1996 paper that perfect return predictions are not possible.
My point is that outsized performance on the up side has historically been matched with outsized performance on the down side. So those good years from 1996 forward (I do not see them as good but the Buy-and-Holders do) might be signaling remarkably bad years up ahead. I hope not.
My preference is that we always stay close to a CAPE level of 17 and to an annual return of 6.5 percent real. I just think that the Buy-and-Holders are making a mistake to take comfort in seeing the unusual results that we have seen from 1996 forward.
I view unusual results in either direction as bad news. This is a core difference in the Buy-and-Hold perspective and the Valuation-Informed Indexing perspective. Buy-and-Holders believe that stock price changes are caused by the performance of the economy. So naturally they view high stock returns as encouraging. I believe that stock price changes are caused by the performance of the economy up to the point at which the return is 6.5 percent real and by investor emotion for returns beyond that level. So I like to see a 6.5 percent return, no more and no less.
It’s all a question of whether irrational exuberance is a real thing or not. Shiller showed that it is. The Buy-and-Holders have never discovered a problem in his research. They just act as if it doesn’t matter and as if we can place the same confidence in the Buy-and-Hold understanding of things as we did in the days before that understanding of things was discredited.
Rob’s bio is here.
