Yesterday’s blog entry reported on an e-mail sent by academic researcher Wade Pfau to me on December 24, 2010. We exchanged several brief e-mails in the following days. The next substantive one was one that Wade sent me on January 5, 2011, in which he recommend that I read the book “Yes, You Can Time the Market!” by Ben Stein and Phil DeMuth because “it vindicates your views about using valuations to guide long-term conservative investors.” My response is set forth below.
Wade:
It’s always good to hear from you. Things are going well with me.
I have read the book. My favorite part is the introduction. Stein there explains what got him started on the path that led to him writing the book. What got him started was the commonsense observation that timing just had to work — for timing not to work would mean that the price we pay for stocks makes no difference in the results that we obtain and that simply cannot be so.
This is a two-step process. First, one has to be persuaded that timing must work. Then one must go about finding the best approach to timing.
On the first question, I am persuaded that we know the right answer –we know that timing works because it is not possible for the rational human mind to imagine a universe in which the price paid for something does not matter. On the
second question, we need to explore lots of possibilities. It’s not possible for us to know anything with much confidence until there has been extensive public debate on numerous possibilities and we are just not there yet. To get that debate, we need to persuade the Buy-and-Holders to ease up on their dogmatism enough to permit a variety of viewpoints to be widely heard.
The focus on 1984 and 1985 is important. I think that the way the price signals work is indeed the flaw to their particular approach.
There is no one P/E10 level at which stocks turn good or bad. People need to understand that the value proposition gradually changes. Any cliff approach is going to fail in some circumstances.
Say that we were trying to say what the perfect highway driving speed is. Some would say “55,” some “60,” some “70.” Some would say “80”! And, if you tested this, you would find that sometimes driving 80 does not lead to an accident. And sometimes someone driving 55 gets in an accident. There is no one correct driving speed. It does not exist.
It does not follow that we should not have speed limits. We must have a speed limit. We know that the danger of driving increases as speed increases. So we just need to reach a consensus that it is okay to drive 65 but not 70 and go with that even though we understand that there is something artificial in setting the speed limit at any one particular number.
This is how it works with stocks. Stocks are more risky when the P/E10 is 15 than they are when the P/E10 is 10. And 20 is worse. And 25 is still worse. And 30 is still worse again. But there is no one magic number. If you say “Sell all your stocks at 30,” you are going to be proven wrong in the eyes of some when the P/E10 continues up to 44, as it did in January 2000.
We need to separate out the things we know (stocks get increasingly risky as the P/E10 level gets higher) from the things we do not know (the precise P/E10 level at which people should sell stocks). What we really need is a change in the way we talk and think about stock investing. We need to become confident enough to make measured statements.
Buy-and-Hold is inherently dogmatic (it posits that there is never a need to make any allocation change). I think this dogmatism has its roots in fear. Investing is so important to us that we demand a level of precision in our pronouncements that it is impossible for us to achieve today. We need to just relax a bit, let in different viewpoints, and stop feeling a need to come up with perfect answers to every question (Buy-and-Hold does not do this, so we should not demand that alternatives to Buy-and-Hold do it either).
We will never come up with perfect answers. The reason why is that there are always two opposite sorts of factors affecting stock prices. There are economic factors, which are highly predictable. And there are emotional factors, which appear to be almost entirely unpredictable. To not make any predictions at all is foolish because the effect of the economic factors is predictable and being able to predict returns reduces risk while increasing return. But to make precise predictions is ALSO foolish because the emotional factors are almost entirely unpredictable and will cause precise predictions to fail regularly.
What we can do is to identify a RANGE of possible long-term returns and assign ROUGH probabilities to each point on the spectrum of possibilities. This is of HUGE value. The Return Predictor tells us that, for stocks bought when the P/E10 is 10, there is a 50 percent chance that you will be seeing a 10-year annualized return of greater than 10.7 percent real and that, for stocks bought when the P/E10 is 20, there is a 50 percent chance that you will be seeing a 10-year annualized return of less than 3.0 percent real. This tells us a lot about how much risk applies in these two different scenarios.
But it does not tell us everything. With a super good returns sequence, you could buy stocks at a P/E10 of 20 and get a 10-year annualized return of 9 percent real. With a super bad returns sequence, you could buy stocks at a P/E10 of 10 and get a 10-year annualized return of only 4.7 real.
No one knows in advance what returns sequence is going to come up. This is determined by investor emotion, which cannot be predicted. We should be making use of what we do know (that stocks carry more risk at higher valuations) while
not pretending that we can know things we cannot know (things that we would need to know to make precise predictions). We CAN time the market, but only in the long-term and not in such a way as to permit precise knowledge of market
tops and bottoms.
Wade sent a brief response later that day expressing surprise re how few views there were at the Bogleheads board for a thread he put up on the effect of valuations on safe withdrawal rates and saying that, based on the research he was doing, he was giving consideration to going with the following title for his next thread-starter at the Bogleheads Forum: “Yes, Virginia, Valuation-Informed Indexing Works!”
Rob
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