An earlier blog entry described the background of my recent correspondence with Michael Kitces on safe withdrawal rates (SWRs). Set forth below is the text of an e-mail that I sent Michael’s way in the evening of Thursday, August 21.
Michael:
Thanks again for providing stimulating feedback.
There’s a punctuation mark that you use in your study that I found entirely appropriate in one sense and extremely odd in another sense. It comes at the end of the sentence in which you put forward the following words: “Those extended periods of expanding or contracting P/E ratios (producing long-term real returns above or below historical averages) can often be anticipated in advance — by looking at the valuation of the aggregate market at the beginning of the time-period.” You employed an exclamation point at the end of that sentence.
Your exclamation point expresses your surprise at the claim being made. That’s entirely appropriate because most investors and most investing experts today do not think of stock returns as being predictable. But It’s also extremely odd that a finding that stock returns are largely predictable would come as a shock to anyone in the year 2008. Whether stock returns are predictable or not is a question of fundamental importance. Can it really be that this reality comes as a surprise to many smart people at this late date?
It really does come as a surprise to many. I have interacted with tens of thousands of middle-class investors on internet discussion boards and most are shocked to hear that long-term returns are to a large extent predictable. But the historical data leaves room for virtually no doubt on this question. Why do people not know this? How is it that this critically important reality is not more widely appreciated?
I believe that the reason why the reality is not better appreciated is because Passive Investing is today’s dominant model for understanding how stock investing works. The Efficient Market Theory tells us that returns should NOT be predictable. If the market is efficient, the market price should always be roughly right. If the market price is always roughly right, it should not be possible to predict future returns by taking into account mispricings.
Your correct statement that knowing the P/E10 of the market helps us anticipate future returns is in conflict with what the the dominant model for understanding how stock investing works tells us to expect from stocks.
The root puzzle is — why were the initial SWR studies set up in the way they were? Why did anyone think it would be a good idea to describe the SWR as a stable number? Why was it not understood from the start that the SWR must change with changes in valuations (as do long-term returns)? The explanation is — the early SWR researchers believed in the Efficient Market Theory and in Passive Investing.
If you are right that returns are predictable (I strongly believe that you are), then the Efficient Market Theory is wrong and the Passive Investing model has failed to properly explain how stock investing works in the real world.
Do you see it that way? Do you agree that the stakes here are huge?
Rob
John Walter Russell says
Why was it not understood from the start that the SWR must change with changes in valuations (as do long-term returns)?
Because they did not believe that a suitable method of measuring valuations existed.
They talked themselves out of seeing anything whatsoever.
It is something of a scandal, of course, routed in poor research by the academics–who wanted to believe their efficient market assumption and who loved the elegance of the theory that surrounds it.
Have fun.
John Walter Russell
Rob says
They talked themselves out of seeing anything whatsoever.
It is my understanding that this may not have been the first time in the history of human life that something like this happened.
Rob
John Walter Russell says
It is my understanding that this may not have been the first time in the history of human life that something like this happened.
I bet that there is a highly charged, emotional story behind what happened [efficient markets and passive investing] but that it will never see the light of day. It is all hidden behind the walls of academia and in some quiet recesses of a few marketing departments.
Have fun.
John Walter Russell
Rob says
I bet that there is a highly charged, emotional story behind what happened [efficient markets and passive investing] but that it will never see the light of day.
Well, it should see the light of day!
This is how we learn — by looking at what we got wrong and seeing how we messed up we discover how not to mess up so much in the future.
The mistake itself is no biggie. That’s all part of the wonderful game. The ugly thing is the resistance to acknowledging the mistake and to doing what it takes to fix it. That stuff is Nowheresville. Yucko McClucko!
Rob
John Walter Russell says
I believe that there are lots of interesting stories hidden inside of faculty lounges.
Have fun.
John Walter Russell