Archives for May 15, 2013

I understand that you believe that stock returns are to some extent predictable. I would be grateful if you could describe the THEORY of how stock prices are set that justifies this belief.

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Buy-and-Hold is rooted in a belief in the Efficient Market Theory. If the Efficient Market Theory were valid, Buy-and-Hold would indeed be the ideal strategy. It does indeed follow from the theory. If stock prices changes are determined by economic and political developments that cannot be identified in advance, risk is a constant and the best choice for the investor is always to remain at the same stock allocation. I do not share the Buy-and-Holder’s belief in the Efficient Market Theory. But I do acknowledge that the strategy follows logically from a belief in the model.

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Valuation-Informed Indexing is rooted in a belief that investors carry within them both a belief that Get Rich Quick can work in the short run and that only common sense can work in the long run. So investors believe that stock prices can go wildly off the mark for periods of time of up to 10 years but that prices always return to fair value over time as investors become alarmed that a widespread reversion to a common-sense belief in how markets work is going to cause a crash and an economic crisis. We have a different foundational belief from the Buy-and-Holders and so we follow a different asset allocation strategy.

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Is there a theory that supports the idea that stock prices are to some extent predictable both in the short-term and in the long-run? If the market were efficient, this would not be so because prices would follow a random-walk pattern. I don’t think it follows from the theory I believe in either because I don’t see why investors would permit prices to get so out of hand if they thought they were predictable in the short term. If investors believed this, wouldn’t they exploit their knowledge of where prices were headed? If the thing that made prices predictable was valuations, wouldn’t the exploitation of the inefficiency cause the mispricing to disappear? Perhaps you believe that it is something other than valuations that makes price changes somewhat predictable both in the short-term and in the long-term.

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The significance of Shiller’s 1981 paper is that it discredited the Efficient Market Theory. Once we knew that the model that supports the Buy-and-Hold strategy was invalid, we knew that the strategy was dangerous. Everyone agrees that price matters in purchases of every possible good or service except for stocks. The only reason why some thought at one time that Buy-and-Hold might work is that they bought in to the Efficient Market Theory. So the big step was the publication of that 1981 research. That was what set us on the right track (or at least what could have done so).

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Shiller certainly did expand on his foundational insight in subsequent work. And of course many others have confirmed his findings and expanded on them. I point to the 1981 research because it removed the foundation belief that caused people for a time to accept that Buy-and-Hold (an exceedingly counter-intutive idea) might make sense.

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I of course don’t believe that everyone “got it” as soon as Shiller published his 1981 research. Few “got it.” In fact, it is still a small number that entirely gets it today. The research is out there, though. There is nothing today that stops us all from getting it other than the Social Taboo that restricts us from talking openly and frankly and expansively about Shiller’s findings. The Social Taboo is the cause of all our troubles in this field, in my assessment. The Social Taboo was formed in 1981 and then grew in strength in subsequent years as the mountain of evidence supporting Shiller’s findings grew taller and taller.

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I don’t see how an investor can know in advance his real return on CDs or corporate bonds. The inflation rate affects the real return. How can you know the inflation rate in advance? If you don’t know your real return, you are taking on risk, more risk than was being taken on by investors who bought stocks at a time when their worst-case scenario return was solid.

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I don’t agree that investors switched to CDs because they thought they knew what real return they would obtain from them. I believe they switched for emotional reasons. They were afraid of stocks. Investors had permitted stock prices to rise to insanely dangerous levels and the price crash that inevitably followed scared them. We are living through a similar set of circumstances today. Buy-and-Hold is the most emotional strategy imaginable. It teaches investors that it is okay to ignore price, which makes investors uneasy because they do not follow this “strategy” in their purchases of any other good or service. The huge losses that inevitably follow confirm their misgivings and they swear off the asset class just at the time when it becomes priced to deliver amazing long-term returns. Those who fall for the Buy-and-Hold marketing mumbo jumbo get hurt on both ends: They buy stocks when they offer a horrible long-term value proposition and then they sell them when they offer a fantastic long-term value proposition. We should be discouraging investor emotion, not exploiting it to the fullest extent. Get RIch Quick strategies provide short-term profits for the industry but the huge losses they cause for the investors who follow them cause so much economic damage that even the industry would be better off if we permitted the experts in this field to give more emotionally balanced advice, in my belief.

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I don’t understand why you say that those who used P/E10 to predict long-term returns would at one time have been “off.” Wade checked the entire 140 years of stock market history available to us and never found a time when things were “off.” The model always works as it is supposed to. I haven’t looked at what would have happened if you looked only at 20 years but it certainly makes sense that those numbers would indeed be off. Looking at 20 years wouldn’t tell you anything of any value. That’s not even close to being a long-enough time-period to help you understand how stock investing works. Bull markets can last 20 years. So the 20-year time period you were looking at might have been an intensely emotional time.

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You might be trying to use the P/E10 values to make precise return predictions. They do not do that. P/E10 tells you how risky stocks are at a given time. So you can use it to identify a range of possible returns and to assign rough probabilities to different points along the spectrum of possibilities. But please remember that in the short term it is emotion that dominates and that emotion cannot be precisely predicted with the tools we have available to us today. Even a time-period 10 years or 20 years out is in part affected by the short-term factors that apply to it. So a precise prediction is not possible.

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Rob