Valuation-Informed Indexing #22: Low Stock Returns Need Not Hurt You As An Investor

I’ve posted Entry #22 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Low Stock Returns Need Not Hurt You As An Investor.

Juicy Excerpt: Investors seeking high returns are not required to take on high levels of risk, under the Valuation-Informed Indexing Model. So there is no penalty associated with going with a low stock allocation or even a zero stock allocation for a time. Valuation-Informed Indexers have opportunities available to them that are not available to Buy-and-Holders. Valuation-Informed Indexers are free to move their money to super-safe asset classes (TIPS, IBond and CDs) at times when stocks offer a poor value proposition.


  1. Arty says


    Happy New Year to you and your family. Hope all are well.

    Question: when you choose to invest in stocks, do you use only the S&P 500 (or its close proxy, TSM)? Or do you diversify across equity classes or internationally? I ask this because your PE/10 valuations use only the S&P.

    And are the podcasts over?



  2. Rob says


    It’s always good to hear your voice again.

    The podcasts are not over by a long shot. I was recording them like a madman for the year after the crash. The crash brought on a partial opening to new ideas, and hearing other people talk about these ideas helped me to take them to places I has not been able to take them in the days when they were being almost entirely ignored. This caused a flood of insights to come into my head and the only way I could get them down quickly enough (If I don’t get them down quickly, I lose the thread) was through podcasts (writing is more organized and thus takes more time). So I just let myself go crazy for awhile.

    I love the podcast form and expect to return to it after I have done more work on the writing side further developing and publicizing the ideas that were sketched out during The Year of Insane Podcasting. Down the road I would like to have a situation where I record one podcast each week (rather than four or five per week, as I did for a time, or zero per week, as I have been doing for the past year).

    The reason why John used the S&P in his research is that we have enough data for the S&P to be able to come up with statistically meaningful insights from it. No suggestion was intended that people should limit themselves to investing in the S&P. (John did not invest in the S&P — he generally invested in high-dividend-paying stocks.)

    Now — there is an important caveat to that.

    Since we have more research on the S&P (it’s not only John who used the S&P for research purposes, lots of people do this), we know more about how the S&P operates. When you understand something better, there is less risk in it. That means that there is less risk investing in the S&P. Thus, it does make sense for some to limit themselves to the S&P. If you are not willing to put time into studying other asset classes, it’s probably not a bad idea to limit yourself to the S&P and piggyback on the many insights about it that have been developed through the large amount of research done on it.

    If you are asking me what I would do with my own money, I would invest primarily in the S&P but also consider other possibilities for smaller percentages of my portfolio. I would not go with the other possibilities unless I was highly confident that I was accomplishing a good purpose by going with them and I would invest in the other possibilities with the understanding that I was increasing my risk a bit by doing so (it’s not necessarily a bad thing to increase risk if you are also likely increasing return).

    One rule I follow is that I never invest in anything unless I feel that I understand it well. So, if aIl felt good about some non-S&P asset class but I did not have the time to do lots of research into it, I would take a pass. I would only invest in a non-S&P asset class if I had the time needed to feel comfortable doing so. I believe that the combination of S&P/Super-Safe Asset Classes (TIPS, IBonds, CDs) does plenty well enough that there is no need to look outside the S&P if you don’t have the time needed to do the research required to do so effectively.


  3. Arty says

    Thanks, Rob. All clear on the preference for the S&P in this context.

    TIPS on TIPS

    When you mention TIPS, I assume you mean individual TIPS selected for specific maturities, rather than a TIPS fund, like say, Vanguard’s VIPSX, where there is an average maturity but no fixed day of maturity? Or do you see the funds as being equally valid options to individual TIPS (they also now have TIPS funds of varying maturities just like nominals), even as these have constant interim price risk?

    Note that in 2008, many who expected TIPS to be “super-safe” were surprised by the liquidity issues (risks) that resulted in their sell-off and losses. Has this affected your view of TIPS in any way?

    When you buy your TIPS, do you hold them to maturity always, or do you sometimes sell them prior—for buying opportunities in the S&P—when stock valuations favor, regardless of the price action in your TIPS?

    Do you ever sell TIPS to lock-in gains on the TIPS themselves? For example, as yields fall (prices rise) do you sell your TIPS? Larry Swedroe (who is very fond of TIPS) uses a strategy for buying and selling them based on prevailing yields, which have a strong tendency to mean revert within their 1%-4% “roaming range” on the 10-year. Or, again, do you always hold to maturity?



  4. Rob says


    These are great questions that get down to the nitty gritty.

    I don’t like TIPS funds. The entire purpose of buying TIPS (in my view!) is knowing exactly what you are going to get. With a TIPS fund, you are getting a mix of things. That brings uncertainly into the picture. I view that as a big negative.

    People who were unhappy with how TIPS performed at a certain time were buying them for entirely different purposes than the purposes for which I buy them. I am a stock guy. I buy TIPS so that I can own more stocks in the long run. So long as they serve that purpose, TIPS are doing what they are supposed to do.

    Whether they continue serving that purpose is determined by how stocks are priced. The TIPS themselves have little to do with it. So the sort of thing you are referring to here is of zero concern to me. I pay no attention to it. I couldn’t tell you what my TIPS are priced at today because I don’t care and I would never bother to look such a thing up.

    I of course understand what you are getting at. You are saying that the market price of the TIPS went down and that made people unhappy. I get it that they are unhappy. My response is that they need to adopt a long-term perspective. Then they would be happy again. The TIPS still represent a better long-term value proposition than stocks. So what the heck is there to be unhappy about re TIPS? It’s because these people do not understand how to evaluate the long-term value proposition of stocks that they are not seeing this.

    What was happening over the time-period you are referring to is that people were in the process of gradually coming to evaluate stocks more realistically. This is a good thing! Because views of stocks became more realistic, the RELATIVE value of TIPS diminished. But if you are investing in TIPS for the reasons that I invest in TIPS (as a place to retain the value of my assets while stock prices return to reasonable levels), you WANT stocks to be properly evaluated. So having the relative value of TIPS diminish is a positive.

    The root problem that these people are having is that they are ignoring the irrationality of the investing project. They are focused on the closing of the difference between the value proposition of TIPS and stocks and, because they own TIPS, they are seeing the closing of that difference as a negative. No! The difference has to be closed entirely to make it worth it for them to move to stocks. You don’t want to invest in stocks unless stocks offer a BETTER value proposition than TIPS (not just a less-worse value proposition).

    And once stocks offer a better value proposition than stocks, happy days are here again! You then sell your TIPS and move into stocks and earn far higher returns than you ever could have earned from TIPS. Again, this is a good thing! People are getting upset to see positive things happen. Many investors are seeing things upside down from how they really are because they start with an assumption of rationality when trying to analyze a process that is highly irrational. They have filters in place in their thinking process that cause them to see precisely the opposite of what is taking place before their eyes.

    I can’t say in advance whether I will hold my TIPS to maturity or not. My HOPE is that I will not. My hope is that stocks will at some point come to offer a better long-term value proposition. When that day comes, I will of course gladly sell my TIPS and use the money to buy stocks. Why the heck wouldn’t I? Why would I want to be in an asset class other than the one offering the best long-term value proposition?

    I don’t WANT to own TIPS. I own TIPS because they provide the most effective protection from the irrational exuberance that came to destroy the value proposition of stocks during the Buy-and-Hold years. I WANT to own stocks. Buying TIPS when stocks are overpriced is a way to come over the course of my lifetime to own more stocks than I could hope to come to own following a Buy-and-Hold strategy.

    I would never sell TIPS to lock in gains on TIPS and I would never vow to hold TIPS to maturity. I hold TIPS for as long as the value proposition on stocks is poor compared to TIPS but only that long. The real money is to made in stocks. TIPS are a secondary asset class in my thinking. The purpose of owning TIPS is to over time come to own more stocks.

    The big gains come from holding stocks, not TIPS. The return on TIPS doesn’t even matter all that much. It only matters to the extent that it makes the long-term value proposition of TIPS better or worse than the long-term value proposition of stocks. The edge for TIPS was 5 percentage points of return in 2000. But I still would have preferred TIPS if the edge had been 1 percentage point of return (that is, if TIPS had been paying a return of zero percent real). I am happy with the other four percentage points of return. But the extra edge is just gravy. I am always going to choose TIPS so long as TIPS offer any edge whatsoever.

    What I cannot understand if why anyone would consider doing otherwise (I think that the answer is that those who believe in Buy-and-Hold do not appreciate that there are times when super-safe asset classes offer a better value proposition than stocks — they are suffering from cognitive dissonance because they are emotionally attached to a strategy they elected to follow years ago, when there was support in the literature for the idea that the market is efficient and that stocks are thus always priced roughly right).


  5. Arty says

    Understood. Not losing is often the winner’s game. Greed works powerfully against that concept.

    Basically, you view TIPS (for example, and potentially other fixed income, should it favor) as at least “holding ground” and preferable to the strong potential of losing ground (to poor stocks valuations).

    Now, at current valuations (PE/10 of 23?) what sort of allocation in stocks do you hold? Clearly, stocks are a bit overvalued by historical measures (PE/10 of 15, say) but perhaps not so far overvalued (again, based on PE/10 history) as to be out of stocks entirely. I’m thinking, by the PE/10 measures, it would not be unreasonable to be 20-30% in stocks now, since a sudden reverse would not be crippling at all—with only that much in beta and the rest in a good buffering fixed income. Obviously everyone has their own risk level. What are your views here?

  6. Rob says

    I agree that 30 percent stocks make perfect sense at today’s prices, Arty.

    I am personally still at zero stocks, however. I don’t recommend that for others. My circumstances are unusual.

    Stocks are likely to do a little better than TIPS over 10 years when selling at today’s prices. That’s the pro case for stocks.

    The con case is that stocks do not return to fair value in the wake of huge bull markets. They go to one-half fair value. There’s not one exception in the historical record (that doesn’t mean that there could never be one, of course).

    The reason is that bull markets cause huge financial destruction. They always bring on an economic crisis (again, there’s not one exception in the record). The crisis makes people value stocks as irrationally on the low side as they earlier valued them irrationally on the high side. Irrational Exuberance always transforms itself over time into Irrational Depression.

    If we go to a P/E10 of 7, that’s a drop of two-thirds from where we are today. If you can live through a two-thirds price drop without selling, stocks make sense today. But if you sell, you don’t get those predicted returns. So you need to be sure you can hold through the rough times.

    I believe that it is far easier to hold if you have a stock allocation of 30 percent than if you have a stock allocation of 60 percent; for someone with a stock allocation of 30 percent, a two-thirds price drop is only 20 percent of total portfolio value while it is 40 percent of total portfolio value for someone with a 60 percent allocation. So I would be very uneasy with a stock allocation of 60 percent. But I think that a stock allocation of 30 percent makes good sense at today’s prices.


  7. Arty says

    All good points, especially the duality of Irrationality. And I agree. The only small caveat is that I think stocks always contain greater risk potential than the *safest* asset classes, even at good valuations—this is just the nature of market risk. But clearly, the forward-looking odds matter.

    Overall, you seem to think like the famous Pascal’s Wager (which contributed to our understanding of probabilities). You weigh the consequences of being wrong vs. the chances of being correct. And you use the Shiller valuation model, mainly, to make that “scale” choice. Thus, on the current stock predictor tool, you’d be gambling too much to expect that 8% return on equities vs. the consequences of being wrong/unlucky.

    Now, you made the only case that can be made for “buy and hold” (the only one I would make)–an allocation or strategy that is willing to hold through the tough times and not sell. But that usually means for most investors, necessarily, a conservative allocation (low Beta) *all the time* (or something like a conservative strategy–like the Harry Browne portfolio). Otherwise, too high in equities would invite surrender to emotions–and bailing out. But the marketing mentality is not geared to the conservative mindset.

    So that I am clear, you are in zero stocks due to personal circumstances, yes? In other words, were those circumstances different (maybe living alone, no family, whatever, etc.) you could see as much as a 30% stocks allocation for yourself?

    If Stocks do only a little better than TIPS, from here onward 10 years, it really makes little sense to be much in stocks if at all, because equity risk is still a biggie, comparatively.

    Still, I do wish TIPS offered a better value proposition today. And with rising yields, they might soon.


  8. says

    The only small caveat is that I think stocks always contain greater risk potential than the *safest* asset classes, even at good valuations—this is just the nature of market risk.

    It’s healthy to have people arguing the other side, Arty. So I am grateful to you for that.

    But I don’t see it myself. If the P/E10 goes to 7, the annual return for stocks if there were no valuations increase ever again would be 6.5 percent real. If valuations returned to fair value, it would be much higher than that. The only way you could get less than 6.5 percent real is if we went to valuation levels lower than we have ever seen before. And we would have to see valuation levels FAR lower than any we have ever seen before for the return on stocks to be poor.

    The one downside I see is that the U.S. economic and political system could collapse. But that’s a risk for TIPS too. In an economic collapse, everything fails. So I don’t see a downside for being in stocks at those prices.


  9. says

    You weigh the consequences of being wrong vs. the chances of being correct. And you use the Shiller valuation model, mainly, to make that “scale” choice.

    That says it well, Arty.

    It’s all about assessing the probabilities of various outcomes and setting up your allocation so that you do well in the event of just about any of the possible outcomes.


  10. says

    But the marketing mentality is not geared to the conservative mindset.

    This is a quibble.

    It’s not a “conservative” mindset. It’s a realistic mindset. I am not a tiny bit opposed to taking risks. But I am very much opposed to taking blind risks. I believe that investors should calculate risks before taking them on and take on only the ones likely to provide a payoff.

    You are of course right that the marketers prefer to push Get Rich Quick strategies because these appeal to the base human emotions and most marketing relies on appeals to the emotions rather than on appeals to reason. To the extent that marketers don’t want middle-class workers to learn the realities, we just need to roll over them. When the middle-class is wiped out, the entire economic and political system is put at risk. This is not acceptable.

    Millions of people have their retirement money invested in stocks. We need to provide them access to honest and accurate reports on what the historical data tells us. This is my sincere belief.


  11. says

    were those circumstances different (maybe living alone, no family, whatever, etc.) you could see as much as a 30% stocks allocation for yourself?

    Yes, that’s right.

    There is no one stock allocation that is right for everyone.

    That’s true at all valuation levels.


  12. says

    I do wish TIPS offered a better value proposition today. And with rising yields, they might soon.

    Fair enough.

    But rising yields might bring stock prices down, no?

    And that might leave you not interested in TIPS at all.


  13. Arty says

    Well, if valuations get to your PE 7 there is still actual equity risk (stuff happens even without the apocalyptic scenario, and a sudden large loss can take a lot longer to rebuild), but in that case—PE 7—I might be highly invested in equities—and I’m conservative. And, of course, in *perception*, it would seem the riskiest time to many others. But it is always that way.

    Look at the March 2009 lows, for example. People still fleeing like lemmings over a cliff. While at the 2000 Tech peak, stocks were *perceived* to be safer, while the reverse was true. Emotions matter, though education of the right sort helps understand how that works. I subscribe to the belief that markets can stay irrational longer than I can stay solvent! And, I’m truly conservative therefore, the most likely scenarios still have me without a boatload of equities, though anything near PE 5 I’d surely stretch a lot more, and for the reasons you mention.

    If TIPS yields rise appreciably, whatever I still have in fixed income would be in TIPS, rather than ST fixed income vehicles as they are now. Valuations matter in Real yields big time, and unlike stocks, the roaming range for TIPS fair value is not nearly as large (really, just 1%-4%, and usually much tighter on average). Plus, you get that inflation protection so you don’t have to fear inflation risk going long on the maturities when you do lock-in. There is a tendency for Real yield to mean revert, and when they do, I’ll be ready for them.

    Locking-in high TIPS yields is a great thing. Of course, you can have circumstances where yields are low (or rather, fixed income returns poor) and stocks also do not return well, though that stagnating environment would hopefully not last long.

    My “conservative” mindset is seen as just way too much so, I fear. And the marketing machine invariable looks to crank the Beta ever higher on investors, with alls sorts of equity “diversification” that all moves in the same direction (down) when diversification is most needed! Plus its more expensive, so I can well understand why you stick mainly to the S&P 500. Really, if you are guessing right with the valuations, it is all that you need.

    Folks are still smarting though from 2008. But if this year is also good, they’ll be primed for another collapse—the bad news seeming long ago—having finally bought in too high, again, when the perception is that all is safe.

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