Set forth below is the text of a post that I recently put to the Quora site:
Is Andrews Smithers Right When He Says That U.S. Stocks Are 80 Percent Overvalued and That We Are in a Bubble Right Now?
Yes, he’s right.
I have studied this matter in great depth. I have spent the last 12 years of my life studying it. Smithers is a top-notch guy. He is NOT a doom-and-gloomer. He is a straight-shooter. He is kind and intelligent. His statements are rooted in a wealth of research.
What is hard for people to understand is how so many good and smart people could continue to tell us to buy stocks when the research shows that stocks are priced at such insanely dangerous levels. The only way to make sense of that is to understand the history of how our knowledge of how stock investing works has developed over time.
Prior to the 1960s, we were in the pre-historic days of our understanding. Stock investing was not the subject of systematic peer-reviewed research. People offered opinions as to how stock investing works. It was pretty much just guesswork in those days.
The first big breakthrough came in 1965, when University of Chicago Economics Professor Eugene Fama published research showing that short-term timing (changing your stock allocation because of a belief as to where prices are headed in the next year or so) does not work. This finding formed the foundation of the Buy-and-Hold concept. 90 percent of the advice you hear today about stock investing is rooted in Fama’s finding and its implications.
People were very excited about this finding and they thought that it was the endpoint of our journey. It turned out that they were wrong. Fama really just took us into the Dark Ages, a time when we knew a lot more than we knew in the Prehistoric Ages but not nearly as much as we would come to know in future days. It was Yale Economics Professor Robert Shiller who supplied the final piece of the puzzle that we needed to finally make complete sense of stock investing.
Shiller did this in 1981. He showed that long-term timing (changing your stock allocation in response to big valuation shifts with the understanding that you may not see benefits for doing so for as long as 10 years) ALWAYS works and is always 100 percent REQUIRED for investors hoping to have any realistic hope of achieving long-term investing success.
Fama wasn’t entirely wrong. It really is so that short-term timing doesn’t work. Unfortunately, Fama stated his conclusions in a sloppy way. He didn’t say that “Short-term timing does’t work,” which is so. He said that “Timing does work,” which is not so. One form of timing (long-term timing) ALWAYS works and is always 100 percent REQUIRED. So Fama’s ideas took us to a very, very dangerous place.
Long-term timing is price discipline. Markets cannot function without price discipline. The thing that makes the car-selling market work is that buyers are always trying to get a good price and so sellers cannot overcharge and get away with it. So long as that dynamic remains in place, the car-selling market can assign prices to cars that are roughly right.
Investors who believe in Buy-and-Hold do not exercise price discipline. They do not spend less on stocks when prices reach insanely dangerous levels, levels at which the long-term return on stocks is less than the long-term return on far safer asset classes like Certificates of Deposit. They stick to the same stock allocation NO MATTER WHAT.
Price discipline is like the brake on a car. The stock market in a time when Buy-and-Hold strategies have become popular is like a car from which the brakes have been ripped out. It is a car headed for a crash.
There is now 33 years of peer-reviewed research, based on 140 years of stock-market history, showing this all to be true. So why doesn’t everyone know about it?
The experts in this field have painted themselves into a corner. They believed in Buy-and-Hold. They built their careers around promotion of it. Then research was published showing that it is not just a little bit off the mark but wildly off the mark. They experienced cognitive dissonance. They couldn’t bear to acknowledge publicly that they were wrong about something so basic. So they have been in cover-up mode for years now.
Evidence Based Investing says
Shiller did this in 1981. He showed that long-term timing (changing your stock allocation in response to big valuation shifts with the understanding that you may not see benefits for doing so for as long as 10 years) ALWAYS works and is always 100 percent REQUIRED for investors hoping to have any realistic hope of achieving long-term investing success.
No he didn’t. Shiller’s work in 1981 did not examine in any way changing your stock allocation in response to big valuation shifts.
Rob says
Shiller didn’t directly examine that question, Evidence. We agree on that much.
But he showed that the market is not efficient. He showed that risk is variable, not constant. If what Shiller showed in 1981 is so, then long-term timing MUST always work. It is a logical impossibility that there could ever be a time when it did not work.
Wade Pfau and I examined that question directly in the peer-reviewed research that we co-authored. We showed that switching from a Buy-and-Hold strategy to a Valuation-Informed Indexing strategy reduces stock investing risk by 70 percent. Wade and I could not have done that how-to research had Shiller not demonstrated the theoretical point three decades earlier. We took what Shiller did to its logical conclusion and thereby gave it value in the real world.
Shiller’s theoretical point possesses zero practical value until we show how much making use of it reduces risk and enhances return. You couldn’t do the second part without doing the second part. But the first part has no value until the second part is done. For 34 years, we have been living in a Twilight Zone re our knowledge of how stock investing works. Shiller discredited the old understanding and told us what we needed to know to move forward to the new understanding. Bennett and Pfau realized the fruits of Shiller’s “revolutionary” (Shiller’s word) finding of 1981.
If you want to give me and Wade the credit for this huge advance, I am obviously okay with that up to a point. But we obviously could not have done what we did had Shiller not did what he did years before. And the next step is to realize that Shiller couldn’t have done what he did had not Fama and the other Buy-and-Holders produced the insights that they produced in the days before Shiller came along. I would never have discovered the errors in the Old School safe-withdrawal-rate studies had I not read Bogle’s book.
Learning is achieved in a building-block fashion. One guy builds a foundation, the next guy adds to it, the next guy sees a block that was placed in the wrong spot and corrects the error, the next guy adds enough blocks to bring the thing to heights that no one imagined at the beginning of the project. Shiller is the one who made it possible for Wade and me to do what we did. What we did was implicit in Shiller’s finding. It was an obvious next step.
I suppose it wasn’t obvious to everyone who came along in the 30 years separating the time between when Shiller produced his finding and when Wade and I published our peer-reviewed paper exploring the implications of Shiller’s work. I think it is fair to say that it will become obvious to everyone who examines our work and comes to appreciate what we showed. You don’t necessarily see all this right away. Your mind is stuck in the pre-Shiller paradigm. Once you let go of that paradigm, all the pieces come together pretty darn quickly.
This is not intellectually difficult stuff. But a lot of people suffer emotional difficulty trying to come to terms with the last 34 years of peer-reviewed research because the new research findings conflict so dramatically with the pre-1981 findings. In an ultimate sense, that’s a good thing. “Revolutionary” advances take us farther ahead than run-of-the-mill advances. But they are harder to process.
I hope that helps a bit.
Rob
stagnation says
“long-term timing MUST always work.”
You’ve been waiting 19 years to get back into the stock market. Not “long-term” enough?
Rob says
Yes, that’s right, Stagnation.
I would prefer to be in stocks. Stocks are in general the best asset class for the typical middle-class investor.
I got out of stocks in the Summer of 1996. That’s nearly 19 years.
You should do some runs with The Investor’s Scenario Surfer. You will see the same general pattern play itself out over and over again. There is often a time when Buy-and-Hold and Valuation-Informed Indexing do equally well. Then there is often a time when Buy-and-Hold goes ahead for a number of years. Then there is a time when Valuation-Informed Indexing goes ahead. Then the differential between the two grows and grows. In the end, Valuation-Informed Indexing is usually far, far ahead of Buy-and-Hold.
That’s what matters, isn’t it? Isn’t it what happens in the long run that matters most. You aren’t investing to buy a car next year. You are investing to finance a retirement that will last for several decades. Doesn’t it make sense to go with the strategy that works best in the long run?
Buy-and-Hold often does super in the short-term. That’s a fact.
That’s why it has such marketing appeal. Most of us humans focus on the short-term. We are programmed that way. We all possess a Get Rich Quick impulse.
But Valuation-Informed Indexing ALWAYS beats Buy-and-Hold in the long term. There has never been a single exception in the 140 years of return data available to us. That’s what is so great about it. It is a virtual sure thing.
But you DO have to have patience. It CAN take a long time for VII to go ahead. If you don’t have the patience, this is not for you. If you are focused on the short-term, VII will NOT work for you. Stick with Buy-and-Hold.
That said, I can tell from your posts that there is a part of you that feels that you SHOULD consider going with a long-term strategy. If you were comfortable with putting your focus on the short-term, you wouldn’t freak out when someone pointed to the 34 years of peer-reviewed research showing the superiority of VII over BH. You freak out because it hurts you to think about how much you have hurt yourself (and others!) by going with the short-term strategy. You will never feel good about yourself until you give up the short-term stuff and move to the first true research-based, long-term strategy.
You can do it in stages if yo like. There are people that move a bit away from Buy-and-Hold and follow what I call “Strategy C.” And there are people who go almost all the way to VII but not quite and follow “Strategy D.” You should choose Strategy C or Strategy D if you are feeling great pain trying to believe in Buy-and-Hold but are not yet entirely convinced that VII is for you.
VII is for long-term investors only. It doesn’t work for those with a short-term focus. Those with a short-term focus need to STAY AWAY. God invented Buy-and-Hold for those with a short-term focus.
Fair enough?
Rob