2011 June 03

I’ve posted a Guest Blog Entry at the Control Your Cash site titled Index Funds Don’t Work in Bear Markets.

Juicy Except: This approach (Valuation-Informed Indexing) sounds so easy and so rewarding and so rooted in common sense. Why doesn’t Mike Piper follow it? Why doesn’t everybody follow it?

Stock investing is an intensely emotional endeavor. When stocks were priced at three times fair value in 2000, the numbers on the bottom line of the last page of our portfolio statements overstated by a factor of three the amount of lasting wealth we had accumulated up to that time. We all wanted to believe that it was the portfolio statements that had it right and the last 30 years of academic research that had it wrong.

We tell ourselves that index funds always work even though there is a voice of common sense within each of us that tells us that it cannot possibly be so. How could there ever be an asset class that is worth buying at any price?

Mike uses numbers in his arguments. But it is emotion that drives his analysis of the numbers and it is emotion that makes Mike’s analyses popular with his readers. Mike and his readers very, very, very much want to believe that index funds work during bear markets. But it is not so, at least not according to the 140 years of historical data available to us today.

Juicy Comment #1: The original Oblivious Investor blog was arguing the difference between passive stock indexes and active stock management – not asset reallocation. He was still wrong because his logic assumed that passive indexes and active funds have access to the same underlying asset choices, which is patently untrue (large funds have access to many foreign securities, derivatives, etc. that individuals don’t get), but your “counter-argument” was arguing a point he didn’t make. That said, you argued it well, so kudos.

Juicy Comment #2: Even your calculator on your site (which is quite interesting, by the way) shows very little difference in 20-30 year returns regardless of the valuation upon investment (moving from a P/E10 of 24 to 36 – or 50% higher – moved 30 year average from 5.8% to 5.68%). So your argument is more apt for people with a shorter timeframe. And in that case you would be talking to people who traditional managers would also agree shouldn’t be fully invested in stocks. So, while it provides a good wrinkle the “answer” isn’t all that different from traditional advice.

Juicy Comment #3: The “fair” valuation does differ depending on the risk-free rate, so during times of historically low interest rates, the P/E should be higher. Not as high as it got in the late 90?s, but your next model iteration should take into account the spread between ROIC and the risk free rate.