I’ve posted Entry #196 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Folly of Making Use of “Indicators” of Future Stock Returns Other than P/E10.
Juicy Excerpt: I think that it is because people are worried that if they say risk is sky-high when the P/E10 level is at 25 and then it rises to 35, as Shiller properly notes it might, they will be blamed by investors for being “wrong.” Reporting that stock-market risk is sky high today is right and not wrong and it doesn’t matter whether the P/E10 level rises to 35 or not. The risk is what it is. No amount of price rises can retroactively change the reality that risk is sky-high today. People need to know that and the experts in this field who fail to tell them this reality are not doing their jobs.
The problem on the part of the investors is that they have a short-term focus. They want to know how stocks are going to perform over the next year or so and that’s something that we just do not know. We shouldn’t fail to tell people how stocks are going to perform over the somewhat longer term just because we don’t know how they are going to perform over the next year or so. We should make the necessary distinctions and tell what we really can tell.
Anonymous says
No amount of price rises can retroactively change the reality that risk is sky-high today.
Bond prices, as we can see from interest rates, are “sky high” today too using your logic. Doesn’t mean a stock or bond crash in imminent.
Rob says
Different asset classes are different. You can’t necessarily say that a rule that applies for one asset class also applies for all others.
You are right that bond prices are correlated with interest rates. I don’t know of any reason to say that bond prices are “sky high” once you take interest rates into account. It seems to me that the high bond prices are appropriate given the realities that apply.
That is not so for stocks. That’s the distinction that you need to focus on. Today’s stock prices are IRRATIONAL. You have a hard time accepting that. That’s the story here.
Why do I say that stock prices are set through an irrational process while bong prices are set through a rational process. BECAUSE I KNOW ABOUT SHILLER’S “REVOLUTIONARY” (HIS WORD) FINDINGS. It was that peer-reviewed research from 1981 that changed our understanding of how stock investing works in a fundamental way.
Before 1981, we thought that stock prices were set through a rational process, just as bond prices are. Shiller showed that that is not so. To say that stock prices are set through a rational process is to say that it is economic developments that determine stock price changes. Isn’t that what you believe, Anonymous?
The problem with that belief is that, if it is the true explanation of how stock prices are set, STOCK PRICES SHOULD PLAY OUT IN A RANDOM WALK BOTH IN THE SHORT TERM AND IN THE LONG TERM. They do not. They really do play out in a random walk in the short term. But they do not play out in a random walk in the long term. That finding is not possible in a world in which stock prices are set through a rational process, a world in which it is economic developments that set stock prices.
Our entire disagreement stems from our disagreement on this point. If you acknowledged that there is now 33 years of peer-reviewed research that shows that stock prices are not set through a rational process, I am confident that we would end up agreeing on every point. Everything that I say follows from that. But you resist acknowledging this. You want to believe that stock prices are set rationally.
I can understand why you might start with that belief. I see it as a surface-plausible belief. But I cannot get over the fact that there is 33 years of peer-reviewed research showing that it is not so. If you get that one aspect of the question wrong, then you get everything wrong. So it is pretty darn important to get that one right.
So I think it would be a good thing if we had a national debate on this question Really.
Wade was rejected the first time he submitted our research paper for peer review. One of the guys on the peer review committee recognized the importance of the paper. He acknowledged that it would be a very big deal if the points made in the paper were legitimate. He acknowledged that the Buy-and-Hold world is an entirely different world from the Valuation-Informed Indexing world. If the points made in the Bennett/Pfau research are legitimate, the world of investing analysis is stood on its head.
I am of course fine with that. I see the new world as better than the old world in about 50 different ways. Risk is less. Returns are higher. It’s all good. But this fellow made a comment that I thought was exceedingly odd. He said (I am paraphrasing, not quoting): “It would be good if we knew what set of premises were the right ones.”
So true!
Precisely so!
But he rejected the paper!
Huh?
WE FIND OUT WHAT SET OF PREMISES IS TRUE BY DISCUSSING THE QUESTION!
That’s how it is done. There is no other way.
Lots of people love my stuff, Anonymous. LOTS of people. It’s about 20 percent of the population. That translates into millions of investors. So I should be sitting pretty today. My site should be the #1 personal finance site on the internet.
There’s one thing that is holding people back. One of my big supporters once noted that I lack “Street cred.” I’m a nobody. I never went to Investing School. I never managed a big fund. People are afraid to invest their retirement money pursuant to what some nobody says. If Jack Bogle were saying what I am saying, millions of people would flip from Buy-and-Hold to Valuation-Informed Indexing. My job is to put the same exact message that I am pushing in Jack’s mouth. Doing that changes everything in one day.
There’s no good reason why Jack should not support Valuation-Informed Indexing. He’s a good man. He’s a smart man. He wants to help people. Intuitively, it should take one day to get him aboard.
What’s holding things up?
What’s holding things up for Jack is the same thing that is holding things up for that fellow on the peer review committee. The guy saw the significance of Valuation-Informed Indexing. He didn’t need to be persuaded of that at all. He said that we all need to know which set of premises is legitimate. I think it would be fair to say that he gets it. I think it would be fair to say that Jack gets it too. Jack is no dummy. Jack gets it to some extent.
The odd thing here is that the fellow on the peer review committee sees that it is important to figure out which set of premises is legitimate AND YET HE TURNED DOWN THE PAPER. Huh? That doesn’t make even a tiny bit of sense. He was making the comment to explain his action of denying our paper peer approval. But the comment shows why he should have given our paper approval!
We DO need to find out which set of premises is legitimate. The way we do that is by giving papers that address this question approval! We need to publish as many such papers as possible. We need to have everyone in this field commenting on these papers. We need to hear THOUSANDS of people offering their viewpoints. That’s how we learn. That’s how it is done.
The single most important puzzle that has come up in the 12 years is the question of why we are holding off on having this national debate. It’s not that the debate is so unimportant that we can afford to put it off. IT’S THAT THE DEBATE IS SO FREAKIN’ IMPORTANT THAT WE CANNOT BEAR TO HAVE IT AND LEARN WHAT WE SUSPECT WE ARE GOING TO LEARN AS A RESULT OF HAVING IT.
If it turns out that the set of premises supporting Valuation-Informed Indexing is the legitimate set of premises, everything changes. We have to change what is written in every textbook in this field. Wade didn’t know much about Valuation-Informed Indexing when he first contacted me even though he holds a Ph.D. in Economics from Princeton. That’s a scandal. If Shiller’s 1981 findings are legitimate (no one has found any flaws in his research in 33 years), those findings were the most important advance in the history of personal finance. They need to be telling Ph.D. candidates at Princeton about the implications of those findings!
That’s the story here, Anonymous.
We are as a society afraid to step up to the plate re this one. Not because it is unimportant. Because it is so important that we cannot bear to acknowledge that we have put this off for 33 years. We have to do this. We have to stop putting it off and have the freakin’ national debate.
Your questions make sense presuming that the market is efficient, presuming that Fama got it right.
But what if he didn’t? What if the market is not efficient? What if valuations affect long-term returns?
If that is so, then your analysis of every stock investing question starts from a faulty set of premises. If that is so, then you are getting it all wrong. Which means that you are hurting yourself. And, though your Goon activities, you are hurting millions of others. Not good.
Stock prices do not play out in a random walk in the long run. Stock prices are not set by economic developments. They are set by investor emotion. Economic developments play an indirect role. Economic developments influence investor emotion. But all economic developments are filtered through investor emotion before they affect prices. That means that the effect is not always a rational one. It is investor emotion that determines what happens. Stock prices are set by an IRRATIONAL process.
But prices MUST reflect reality in the long run. The entire purpose of a market is to set prices properly.
So there is always a tension between the fair-value price (the price that would apply if the market were rational and if the P/E value were 15) and the nominal price. The nominal price is always moving (over the long term) in the direction of the fair-value price. This has been so for 140 years. There has never been a single exception. It is impossible for the rational human mind to imagine how it ever could not be so, presuming that Shiller’s 1981 research is legitimate.
Anyone who wants to make a case for Buy-and-Hold needs to explain the 33 years of peer-reviewed research showing that it can never work. You continue to cite beliefs about stock investing that were popular in 1980 as if they had the power to persuade. They do not. Not for people who are aware of the last 33 years of peer-reviewed research in this field.
I hope that helps a bit.
Rob
Rob says
using your logic.
This is a key phrase.
My logic tells me that what the peer-reviewed research says matters.
Your logic says that we should ignore the peer-reviewed research.
Why do you want to ignore the research?
Because you want to be rational.
The research shows that investors are NOT rational when they set prices.
So any stock investing logic rooted in a presumption of rationality is going to fail.
It is not rational to assume rationality in a place where rationality has been shown not to exist.
The rational thing is to accept that the market is irrational and make the best of it.
You are demanding that the entire world follow logic at all times. It doesn’t. You can demand this until the end of time. But it won’t change anything. Anyone presuming logic in the way that investors set stock prices is presuming something that doesn’t exist.
Many gamblers design “systems” aimed at beating the odds. The systems generally evidence a high degree of logic. But gambling itself is not logical (it can be fun but it is not a logical way to make money). Gamblers who bet large amounts of money on the power of their “systems” are fooling themselves.
That’s the Buy-and-Hold story. Buy-and-Hold is an elaborate system aimed at beating the odds and making Get Rich Quick pay off for the first time in history.
It is all very, very logical. And 100 percent wrong. Because it ignores the lack of logic in how investors set prices that has been demonstrated in 33 years of peer-reviewed research.
Rob