Set forth below is the text of a comment that I recently posted to another blog entry at this site:
If stock markets level out and volatility falls, then to my mind the equity risk premium would dry up and stocks would be indistinguishable from bonds.
You are trying to make sense of things through the use of concepts developed by people who believed in the Buy-and-Hold Model, Laugh. This cannot be done.
Stock prices are determined by the productivity of the U.S. economy, not by market forces. The idea that stock returns are high because stocks are a volatile asset class is part of the Buy-and-Hold mythology. There is zero support in the academic research for this “idea.” Volatility is risk. Volatility is a bad thing. Volatility adds nothing. We will all be better off when volatility is greatly reduced. A big reduction in volatility will be the greatest free lunch we have ever enjoyed.
Look at where things stood in 2000. Stocks were the riskiest they have even been in history. So there should have been a huge risk premium, right? Investors should have been looking forward to long-term returns of 15 percent or 20 percent real as their reward for being willing to take on that sort of risk, according to the risk-premium advocates. Yet the research tells us that the most likely annualized long-term return in 2000 was a negative number. Huh? You take on more risk than any stock investor before you has ever taken on and your compensation is a negative return? That makes sense? There was a risk PENALTY in place in 2000, not a risk premium.
The error that the Buy-and-Holders continually make is to ASSUME investor rationality. Rational investors would demand a risk premium. That much is certainly so. Like everything else in the Buy-and-Hold Model, the risk premium is 100 percent logical. That is the problem.
Stock investing would be 100 percent logical if only the human investors who buy and sell stocks were 100 percent logical. They are not. So the idea that any model for understanding investing that ASSUMES 100 percent logic could ever work in the real world is of course 100 percent nonsense.
You MUST incorporate investor emotion into the mix. That’s what P/E10 does. P/E10 tells you how irrational investors are being at any given moment.
The magic of permitting honest posting on what the academic research says is that the humans can CORRECT their irrational behavior by looking at the research. It was an insane act to go with a high stock allocation when the likely long-term return for stocks was a negative number. Now consider how the Buy-and-Holders and the Valuation-Informed Indexers cope with this reality. The Valuation-Informed Indexers let investors know what the research says, that they are destroying their hopes of being able to retire when they want by giving in to the Get Rich Quick urge that says that price means nothing, to just go ahead and buy stocks no matter how dangerously overpriced they are. The Buy-and-Holders take it just the other way. They say that there is some magic pixie dust that they are sprinkling in the air to make stock investing work 100 percent the opposite of how it has always worked throughout history, that it is JUST FINE to stay at the same stock allocation when prices go to insanely inflated levels.
That’s why those who listen to the Valuation-Informed Indexers always end up so far ahead. VII is HONEST. Honest investing advice helps the investor more than does the Get Rich Quick garbage pushed so heavily by the Wall Street Con Men.
Or at least that is my sincere belief re these important matters, Laugh.
Please take good care.