A friend of mine set me an e-mail when stock prices started falling a few weeks back. His stock broker had sent him an e-mail making the case for “buying on the dip.” My friend knows that I place a lot of focus on stock valuations. So he asked me what I thought about the broker’s recommendation.
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I certainly didn’t think much of it. Stock prices have fallen by a significant amount in recent weeks. All humans employ “anchoring” to make relative comparisons. When gasoline has recently been selling for $2.50 per gallon, we react to a price of $2.00 per gallon as being shockingly low. When it has recently been selling for $1.50 per gallon, we react to a price of $2.00 per gallon as being shockingly high. Our recent experience has a great influence on our assessment of what values are the right ones. Since stocks have in recent memory sold at a higher price than the price at which they are selling today, the claim that today presents an opportunity to “buy on the dip” possesses surface appeal.
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But of course the reality is that recent prices tell us next to nothing about intrinsic value. What investors want to do is to buy stocks when they offer a strong long-term value proposition and not to buy them when they offer a poor long-term value proposition. Shiller’s CAPE value gives is the information we need. The fair-value CAPE is 16. When the CAPE is less than 16, stocks are a buy. As the CAPE value rises more and more above 16, the value proposition diminishes. The CAPE value today is 27. Stocks are a terrible value. The fact that the CAPE value was 32 not too long ago does not change that.
Determining The Intrinsic Value Of Stocks
That’s a simple enough analysis. But I know from experience talking with investors that it is an exceedingly controversial one. Most investors do not believe that it is possible to determine the intrinsic value of stocks. The Buy-and-Hold Model encourages that skepticism. Buy-and-Holders discourage market timing. If it were widely accepted that it is possible to identify intrinsic value, the merit of market timing would be self-evident — investors would want to own more stocks when intrinsic value was strong than when it was weak. Buy-and-Holders begin with a premise that market timing is a bad idea and thus feel logically forced to conclude that making an accurate assessment of intrinsic value is not possible.
But is it an objective fact that the median CAPE value for the time-period in which we have good records of stock prices is 16. The CAPE value has obviously risen far above that at times. But prices have always eventually dropped from those high levels. And the CAPE value has obviously dropped far below that at other times. On those occasions, it eventually rose above those low levels. Since 16 is the CAPE value to which stock are always moving, is it not fair to say that that number reveals the intrinsic value of stocks and that the current-day price is merely a temporary resting place at which the price sits for a time while the market shakes off its irrational exuberance or its irrational depression?
The CAPE value has been well above 16 for a long, long time. Shiller published a paper in July 1996 warning investors that, if they stuck with their high stock allocations despite the high prices that applied at the time (the CAPE was 25 in those days), they would live to regret it within 10 years. Prices increased by 126 percent over the next four years. And we did not see the price crash anticipated by Shiller until late in 2008. That crash brought the CAPE down to 13 for a few months in early 2009 but the CAPE shot up much higher by the end of the year and has remained at super high levels until today. Today’s CAPE of 27 — a reading taken several months into the coronavirus crisis — is a notch higher than the CAPE value of 25 that Shiller was warning about in 1996.
Interpretation Of Price History
Buy-and-Holders and Valuation-Informed Indexers interpret that bit of price history in different ways. In the eyes of the Buy-and-Holders, it tells us that this business of seeking to determine the intrinsic value of stocks is silliness. Shiller obviously was not able to do it successfully in 1996. And anyone who went with a lowered stock allocation from 1996 forward “missed out” on the far-above-16 CAPE values that we have “enjoyed” (the Buy-and-Holders enjoyed those high CAPE values, I have not) in the days since.
For a Valuation-Informed Indexer, the fundamental rules apply. The fair-price CAPE value was 16 in 1996 and it remains 16 today. If it is possible for us to see a long stretch of years in which the CAPE never drops below 16, it is equally possible for us to see a long stretch of years in which the CAPE never rises above 16. Can you imagine how a stretch of years like that would play on the minds of today’s investors? To drop to 16 would require a 50 percent price drop from where we were just a few months ago. To drop below that and then remain there for many years would be deeply upsetting to those who think of purchases made when the CAPE is 27 as “buying on the dip.”
The Best Indication Of Recent Values
It’s a matter of perspective. Buy-and-Holders think of recent prices as the best indicators of recent values because Buy-and-Holders believe that it is economic developments that determine price changes and that recent prices thus give us the best indication of recent values. Valuation-Informed Indexers believe that irrational exuberance affects recent prices to a greater or lesser degree at all times. When the irrational exuberance is as much out of control as it has been since 1996, none of the current-day prices that applied during those years count for much. It is intrinsic value that matters and to know that we need to determine what the size of our portfolio would be if the CAPE returned to its fair-value resting place.
I don’t trust stock prices that produce a CAPE of much above 16. I believe in “buying on the dip.” But I don’t believe that the dip is genuine until it takes the CAPE below 16. The fair-value CAPE number is the product of 150 years of historical return data. The idea that most of us have in our head that CAPE values far greater than that are meaningful indicators of value is the product of a much shorter number of years of stock market history.
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