Valuation-Informed Indexing #188: Shiller’s Mistaken Understanding of Why Only Long-Term Returns Are Predictable

I’ve posted Entry #188 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Shiller’s Mistaken Understanding of Why Only Long-Term Returns Are Predictable.

Juicy Excerpt: The term “noise” suggests a meaningless factor, a factor that need not be given much consideration. The Buy-and-Holders are using the term properly, Shiller is not.

Buy-and-Holders believe that the returns of greater than 6.5 percent real and the returns of less than 6.5 percent real pop up randomly. Returns are determined by unforeseen economic and political events, in the Buy-and-Hold Model. Thus, deviations from the normal return cannot be predicted. The deviations are noise, distractions from the reality you should be keeping in mind at all times, the reality that the average long-term return is 6.5 percent real.

Under Shiller’s model, the deviations are NOT random and meaningless events. The reason why returns are predictable in the Shiller model is that the model posits that it is investor emotions that are the primary determinant of price changes. Emotional extremes in one direction beget in time emotional extremes in the opposite direction. High prices increase the probability of price drops and low prices increase the probability of price rises. There’s nothing “noisy” (or random, or meaningless) about this process. It is the essence of how stock investing works, according to the Shiller model.

Comments

  1. x says

    returns are predictable in the Shiller model

    Predictable by using your calculator? In 2004 the PE10 held fairly steady around 27. At the level your calculator says the “most likely” ten year return is 1.10%, and “best possible” is 7.10%. The current ten year return on the S&P 500 index is 8%. Even within your extremely wide range of “predictable” results, your calculator totally blew it.

    Of course I don’t expect this comment to survive your delete hammer. Or perhaps you will reply that short term (ten year) results aren’t predictable. In that case, your calculator is rather irresponsible to make ten year predictions.

    Hope you enjoyed your vacation.

  2. Rob says

    The range of possible returns offered by The Stock-Return Predictor is neither extremely wide nor extremely narrow, X. It is an accurate record of what the historical record tells us, nothing more and nothing less.

    There is only a 5 percent chance that the lowest possible return will not be surpassed or that the highest possible number will be surpassed. You should expect the highest possible number to be surpassed once every 20 years or so. So what? Knowing that in 2004 there was only a one-in-twenty chance that you would see a 10-year return of more than 7 percent on your purchase of an index fund was extremely valuable information. In 1982, the most likely return was 15 percent real. Do you not see that that means that the stock market offered a far more powerful long-term value proposition in 1982 than it did in 2004? I mean, come on.

    The comment survived the delete hammer because the comment offers value to people trying to learn how stock investing works in the real world. Long-term return predictions ALWAYS work. That’s been so for 140 years now and it is hard to imagine that it will ever stop being true given the long track record. All the same, there are limits to the precision that can be achieved even with long-term predictions and people need to know that. I am grateful to you for pointing out a case in which precision was certainly lacking.

    I did enjoy the vacation. The waves were super. I think it would be fair to say that a reasonable definition of “good luck” is having it rain only one time on your vacation and having that be at night when you are asleep. Another lucky thing is that I wanted to see a sunrise but I didn’t want to set an alarm to wake me up in time. One morning I woke up at 5:30 am on my own and was able to get on the beach in time to see the sun come up at 6:13 am.

    It sounds like somebody has God on his side!

    Uh-oh!

    Rob

  3. Rob says

    How large would you say the range of possible returns is for Buy-and-Holders?

    We could see a 90 percent price drop with Buy-and-Hold. We could see a 90 percent price increase with Buy-and-Hold. Is that what you would call a nice, small range of possible outcomes?

    Buy-and-Hold is a DISASTER at making effective predictions. Buy-and-Holders don’t even offer any freakin’ predictions, much less get them reasonably on the mark.

    Valuation-Informed Indexing is not perfect in every possible way. But it is the absolute best that we can do with the peer-reviewed research available to us today. And it leaves Buy-and-Hold miles behind in the dust. The two models do not even compare re the accuracy of the predictions offered. The Buy-and-Holders DO NOT EVEN TRY to offer predictions, whether good bad or indifferent.

    Holy moly!

    When I put my retirement money at risk, I want to have some sort of idea what long-term value proposition is going to be delivered. Valuation-Informed Indexing gives me that. Buy-and-Hold? Not so much.

    Not this boy. Please try to find someone else.

    Yucko to all the smelly Buy-and-Hold garbage!

    That’s my sincere take re this widely touted Get Rich Quick scheme, in any event.

    Rob

  4. x says

    Just by eyeballing a PE10 chart against a rolling 10 year SP 500 return chart, it’s obvious your calculator’s “Best Possible” return was way too low for the entire decade of 1990-2000. That’s a long string of “5 percent chance” errors, not to mention a lot of bitter regret for anyone who sold their all their stock in the 90s on that basis.

    In 1982, the most likely return was 15 percent real.

    Great, but that was over 30 years ago. And to see 1982 levels again you have to go back 50 years before that. Suppose we have to wait another 20 years for “cheap” stocks. By that time most of us won’t have much time left to enjoy those wonderful returns.

  5. Rob says

    This is a super comment. The two drawbacks of Valuation-Informed Indexing are that short-term return predictions do not work and that even long-term return predictions do not work with a high level of precision. You are helping people understand the two primary caveats that apply. That’s good stuff.

    The last bull market was the biggest ever seen in history by far. So it makes sense that the returns obtained during it were bigger than what would be predicted by making reference to the historical record. I believe that it was the popularity of the Buy-and-Hold strategy that caused things to go haywire.

    It would have been foolish for most investors to have “sold all their stock in the 90s.” There are about 500 statements at this site at which I make that point. I personally went to a zero stock allocation in the Summer of 1996. But my circumstances were highly unusual. Most investors should have been sticking with perhaps a 30 percent stock allocation even from 1996 forward. They would have enjoyed all the benefits of the bull from 1982 through 1996. They would have avoided both the slow-leak crash from 2000 through 2008 and the dramatic crash we saw in late 2008 and the 65 percent crash that the research says is coming in another year or two. That would put them way, way, way ahead of the Buy-and-Holders over their investing lifetimes, hundreds of thousands of dollars ahead. You can check how this works with The Investor’s Scenario Surfer. It is true that they would have missed out on most of the gains from 1996 through 1999. That’s the price you pay for gaining access to a strategy that reduces risk by 70 percent while providing far higher long-term returns.

    Great, but that was over 30 years ago.

    Stocks remained reasonably priced until 1996. It is true that there has been a long stretch of time in which stocks have NOT been reasonably priced. That’s because of the Ban on Honest Posting. Once we open the internet up to honest posting, there will be lots of selling and prices will be pulled back to reasonable levels (and returns will rise back to acceptable or better levels!). You can’t blame this one on the Valuation-Informed Indexers. It is you Goons who are making it impossible for millions of middle-class investors to obtain the information they need to invest in a research-backed manner.

    We all should be working together to overcome this problem. It’s OUR stock market! It’s OUR economic system! It’s OUR country!

    Rob

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