Shiller Showed That Valuations Matter, the Return Predictor Shows How Much They Matter

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Valuation-Informed Indexing #299

by Rob Bennett

“The P/E10 tool could drastically change how the entire investment industry operates and measures risk.”

That’s a comment sent to me by my friend Larry Evans after he spent two months of his life reading every article at my web site and thinking though the implications that follow from the points made in them. Larry was not a friend on his first visit to the site. He was a polite skeptic. He found the core idea of the Valuation-Informed Indexing concept absurd.

He observed in a comment posed to the discussion thread for a blog entry that it appeared that I was advocating a form of market timing (I do indeed advocate long-term timing — price discipline — but not short-term timing). I told him that that was indeed the case. He said that that could not possibly work; every expert he had ever heard has said otherwise. I said that many smart and good people shared his point of view but that I did not. He offered to spend two months reading every article at the site if I would agree in advance to post an article he would write saying what he thought of the Valuation-Informed Indexing concept after studying it in depth. I said that that sounded good to me.

After two months. Larry called me and we talked for several hours about the good that this new investing model (rooted in Robert Shiller’s research) could do for the world. The following day he sent me an e-mail containing the words quoted above. Larry put Valuation-Informed Indexing concept to the test and a skeptic became a believer. It happened the same way with me (I was once an enthusiastic Buy-and-Holder). And with John Walter Russell. And with Wade Pfau. And with scores of others.

I would like to see it happen with millions of others. But that hasn’t happened yet by a long shot. So I often ask myself what it is that people need to hear to bring them around. I believe that the answer is — they need to work the numbers. The research-backed finding that exercising price discipline when buying stocks can reduce risk by 70 percent is a highly counter-intuitive reality. People find it impossible to believe until they see the numbers for themselves.

The purpose of The Stock-Return Predictor is to put those numbers before people in a clear and easy-to-understand format.

The investor enters a valuation level that he would like to examine and the calculator performs a regression analysis of the 145 years of historical return data available to us today to reveal the most likely annualized 10-year return on a stock purchase. Enter the super-low valuation level that applied in 1982 and you learn that the likely annualized 10-year return on stocks is 15 percent real. Enter the super-high valuation level that applied in 2000 and you learn that the likely annualized 10-year return on stocks is a negative 1 percent real. It does not make sense to maintain the same stock allocation at all times. Stocks at some prices offer a powerful value proposition and stocks at other prices offer a terrible value proposition.

It’s just like with anything else that can be purchased with money!

It’s the opposite of what the Buy-and-Holders say. Timing always works. And it is always required for those seeking to keep their risk profile roughly stable (stocks are obviously a more risky proposition when the likely long-term return is a negative number than when it is a double-digit positive number).

The Stock-Return Predictor tells you the price tag attached to the stocks you buy. None of us would consider buying anything other than stocks without first looking at the price that applies. But we do it all the time with stocks. We once didn’t know that long-term timing is always required or even that it always works. We heard that short-term timing doesn’t work and just assumed that the same was so re long-term timing. We developed a habit of buying stocks without taking price into consideration and thereby greatly diminished our long-term return while greatly increasing the risk we took on earning it.

The Stock-Return Predictor puts an end to all that for those who take its powerfully liberating message — price matters when buying stocks as much as it does when buying anything else — to heart. Engaging in the form of market timing that always works is something that you want to be certain to do, not something that you want to avoid doing. The claim that market timing is dangerous is itself dangerous (even though unintentionally so, to be sure).

It’s a simple tool. But it changes the stock investing experience in a fundamental and profound way. We have long believed that stocks are an inherently risky asset class. The Return Predictor tells us that, when stocks are priced as they were in 1982 (a P/E10 value of 8), there’s a 95 percent chance that the annualized 10-year return will 8.5 percent real or higher. All possible outcomes are mouth-wateringly good. What’s the risk in that? To be sure, there’s still a great variance in the possibilities. There’s a 5 percent chance that the annualized return will be greater than 20.5 percent real. That’s much better. But the usual understanding of what the word “risk” signifies does not apply when there is virtually zero chance that the outcome will be poor.

I was not surprised to see the calculator report that it is better to buy stocks when they are low-priced than when they are high-priced. But I was shocked to learn that the expected 60-year return is not much different regardless of the valuation level that applies at the time of purchase. But I’ve learned to accept what the data is telling me and that I need to alter my preconceptions rather than ignore the data when the two do not fit together well. After a good bit of further study and lots of discussion, I came to see why that’s so. Stock prices follow a predictable long-term pattern of about 20 years of rising valuations followed by about 15 years of falling prices. Go far enough out and the good years cancel out the bad years to an extent sufficient to make the average long-term return (6.5 percent real) the one that applies.

That’s close to what the Buy-and-Holders say. But not close enough. It is the first ten years of a retirement that have the biggest effect on whether a retirement plan succeeds or fails. Once a retirement plan fails, it’s game over — the return that theoretically would have applied 60 years out just doesn’t matter. The Stock-Return Predictor supplies the investor with the numbers he needs to plan effectively in the real world — the 10-year numbers, the 30-year numbers and the 60-year numbers. Knowing that the average long-term return is outstanding really is important, just as the Buy-and-Holders often observe. But it is not the only thing that is important. Not by a long shot.

Rob Bennett’s bio is here.

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