Set forth below is the text of a comment that I recently posted to another blog entry at this site:
Here’s what a team of Vanguard PhDs and CFAs say:
Figure 2 reveals that the predictability of valuation
metrics has only been meaningful at the 10-year
horizon. Even then, P/E ratios have explained only
approximately 40% of the time variation in real
I view the Vanguard paper as being highly supportive of Valuation-Informed Indexing principles. At one point it states that “returns are better stated in a probabilities forecast” and that in the short term returns are not predictable at all. That’s Valuation-Informed Indexing! That’s what I have been saying over and over again since the first day. That’s what the Return Predictor shows. So I have not until now been able to figure out why you keep bringing up this paper.
I re-read your comment above and it hit me. I say over and over again that valuations are 80 percent of the game and the paper says that P/E ratios explain only 40 percent of the time variation in real returns. You are viewing the difference between the 80 percent number and the 40 percent number as a discrepancy.
I am NOT saying that valuations are responsible for 80 percent of the return in any given year. I stand by my statement that understanding and acting on valuations is 80 percent of the strategic stock-investing game.
There are two broad types of factors that affect returns: (1) rational factors; and (2) irrational factors.
The rational factors are all the things that should and do affect stock prices, all of the things that affect the profitability of the underlying businesses. Fama showed that all of these factors are quickly incorporated into the price of stocks. The Valuation-Informed Indexer does not dispute this finding. We endorse it. The Vanguard study is saying that all of these factors added together comprise 60 percent of the price.
The irrational factors are the emotional factors that cause mispricing (overvaluation or undervaluation). These factors are non-business, non-economic factors. They are emotional factors. The significance of these factors at any given point in time is signaled by the P/E10 value.
As an investor there is nothing you can do about the 60 percent of rational factors. So no strategic considerations come into play. If rational factors determined 100 percent of the market price, the market would be efficient (because there would be no emotional factors throwing things off) and Buy-and-Hold would be the ideal strategy. If there were no emotional/non-rational factors to take into consideration, risk would be constant. The investor would always be justified in having an expectation of a long-term return of something near 6.5 percent real.
There IS something you can do about the 40 percent emotional factors.
This study (and every other study that has looked at the question in an even remotely reasonable manner) shows that the market is NOT efficient and that RISK is variable, not constant. Buy-and-Hold does NOT make sense. Investors MUST change their stock allocations in response to big valuation shifts to have any hope whatsoever of keeping their risk profiles roughly constant over time.
The 40 percent of the total return that depends on the P/E10 level is the only portion of the total return to which the investor can respond in a strategic way. The logical response is to increase one’s stock allocation when prices are low and risk is low and to lower one’s stock allocation when prices are high and risk is high. That’s Valuation-Informed Indexing. That’s the entire concept. That’s the approach that lowers stock investing risk by nearly 70 percent, according to the famous Bennett/Pfau research paper (the only research paper so compelling that it caused the Buy-and-Holders to threaten to destroy the careers of the two authors of the paper so desperate was their desire to keep millions of middle-class investors from learning about its findings).
Valuations are not 100 percent of what determines the market price. Rational, economic factors obviously play a huge role. But there is nothing that the investor can do about those factors. They are a given.
The investor MUST change his stock allocation in response to the 40 percent of emotional factors. So far as allocation changes go, valuations are 100 percent of the game. There is no other factor that permits a high degree of predictability, according to the research. So I believe that valuations are the ONLY factor that an investor should be looking at when making the necessary allocation changes.
I reason why I don’t say that valuations is 100 percent of the game is because there are considerations other than getting one’s stock allocation right that come into play. For example, it makes sense to limit one’s fees. If one company has lower fees than another, that will affect the investor’s long-term level of success. That is a non-valuation factor. Another example of a non-valuation factor that matters is that most investors should be going with index funds rather than picking individual stocks. Failing to go with indexes is not a fatal mistake. But I do believe it is a mistake for all investors except those who possess the skill and willingness to do research needed to win at the stock-picking game.
My claim is that getting your stock allocation right is the most important thing (80 percent of the game). And that the investor MUST take valuations into consideration to get his stock allocation even roughly right. If you ignored valuations, you might have gone with a 74 percent stock allocation in 2000 (the Greaney study identified this allocation as “optimal” at all times). If you considered valuations, you probably went with an allocation of about 20 percent. That’s a big difference and getting that one right is going to pay off big time in the long run if valuations are indeed responsible for 40 percent of the market price (that is, if stocks continue performing in the future anything at all as they always have in the past).
The Vanguard study shows that the valuations factor is huge. It is the ONLY significant factor to which the investor can respond in an effective manner. All he needs to do is to look at the P/E10 value and make the required allocation changes. If he fails to do that, he hurts himself big time.
There is no excuse for any investment advisor to fail to stress the importance of valuations in the year 2014. A factor that determines 40 percent of the market price is far too important a factor to be ignored. I would go so far as to say that it is financial malpractice for any advisor to ignore the valuations factor (responsible for 40 percent of the market price according to Vanguard!) in the year 2014. Shiller did not publish his revolutionary research last week or last month or last year. He published it in 1981. That’s 33 years ago!
There are legitimate differences of opinion as to HOW MUCH one should change one’s allocation in response to valuation shifts. That’s why we need a national debate on these questions. We need to get all viewpoints re these matters aired! But the issue of whether valuation-informed allocation changes are required for those seeking to have some realistic hope of long-term investing success has been settled beyond any reasonable dispute. Even Vanguard (the lead promoters of Buy-and-Hold investing strategies) is on board! Bogle hasn’t given his “I Was Wrong” speech yet but the company he founded has published research showing why he needs to make it to come clean about false and deceptive claims he has made in earlier days which have done great financial harm to millions of middle-class investors.
Come clean, Old Saint Jack!
Do it before the close of business tomorrow!
Don’t worry about Mel Lindauer! I will take over the Bogleheads Forum and I will protect you from him!