Set forth below is the text of a response that I posted to a comment by Aaron Rainey on one of my Valuation-Informed Indexing columns at the Value Walk site:
Rob, you are only mad because Shiller did not give you a binary response (buy/sell) to his view of the market. Market models are not binary or absolute systems and they are closer to probability systems. With the lack of a binary response you put together a pretty lame attempt to disparage his article. The fact that you would be mad about the lack of a binary response and paragraph 8 comment shows your lack of understanding around the markets, market models and the analysis of markets.
I run my own database and create my own market analytics and I did not recreate any of Shiller’s metrics and while his metric calls for a -32% correction my own metric came in with a correction off -31% percent. The point being; Shiller is quantitatively correct and statistically accurate. More importantly he gave people an accurate and fair warning in which they can base their financial decisions. If those reading his statement are not able to discern the meaning that is their problem; not Shiller’s.
If you look at Shiller’s comments objectively and from a higher-level you can begin to understand his point. For example, posing the following statement to you, if you were told that investing in the S&P 500 today you have the potential of making 6%, but you also run the risk of losing 32% … what would you do??? The answer is quite clear and obvious and the only people that would take issue with this answer is someone who being greedy and really NEEDS the 6% for some reason.
In very basic terms, the above is what Shiller is communicating in his article. In terms of plain English; you can chase the upside if you got the guts, but there is significant downside risk. If your choice is to chase the upside, then don’t cry about it if you get burned.
It doesn’t get any easier and you really should issue an apology article.
A follow-up comment by Aaron stated:
Also, after reviewing your stance on “Valuation-Informed Indexing” you are directionally correct, but still pretty far off the correct solution because you are not looking at the problem correctly.
I LOVE your comment, Aaron. I don’t agree with parts of it. But it hits at the most important points in a way that not too many comments that I have seen in response to my work do. I am grateful to you for taking time out of your day to share your thoughts with us.
I agree 100 percent with your statement that the stock market is a probability system. This is the thing about the market that I believe most people either do not get or have not explored in enough depth to appreciate in full. We never know where stocks are going over the next six months or the next year. But we always have a rough idea of the probabilities of various outcomes over the long run. We should be talking about those probabilities. To talk about them intelligently, we need to QUANTIFY them.
You gave a sample of what a quantification of the going-forward probabilities might look like — “You have the potential of making 6 percent but you also run the risk of losing 32 percent.” There are two things missing in that statement. One, you need to say over what time-period those probabilities apply (I presume that you might have meant over the next year but I am not sure). Two, you need to explain that there is more than one set of probabilities that apply. The 6/32 may be the most likely scenario but there is always more than one.
I don’t think that telling people “you can chase the upside if you want but you might get burned” tells them what they need to know. The general statement is always true. The reality is that the upside is very different when the P/E10 is 8 than what it is when the P/E10 is 30. And the downside is also very different in those two sets of circumstances. You need to let people compare and contrast both the upside and the downside at different valuation levels. That tells them what they need to know to know how much to adjust their stock allocation in response to various price increases. It’s that compare-and-contrast information that makes Shiller’s finding that valuations affect long-term returns ACTIONABLE in the real world.
You suggest that anyone who read Shiller’s words carefully would see that the potential gain from going with a high stock allocation today is too great to justify the potential loss. I agree with that. But please understand that most investors are not inclined to read Shiller’s words that carefully. We all have a Get Rich Quick urge within us. We all have a naturally inclination to believe that we are going to see the best possible result and avoid the worst possible result.
People of course have a choice as to how to proceed. But we cannot expect people to take the responsible course unless we are very clear and firm in our statements as to both the upside and the downside. People tune out warnings that are worded in the way that Shiller words his warnings. He needs to be more clear. He should tell people how many years they are delaying their retirements by going with a Buy-and-Hold strategy. People need to know how dangerous and irresponsible Buy-and-Hold is. Shiller is not getting that point across forcefully enough, in my assessment.
This is why we have bull markets. If investing analysts offered informed takes of how much the value proposition of owning stocks drops as prices increase, investors would act in their self-interest and lower their stock allocations gradually as prices increased. The selling of shares would pull prices back down to fair-value levels. Stock prices are self-regulating so long as investors are informed of the realities! The reason why we have bull markets is that investment advisors are strongly biased in the direction of overselling the benefits of owning stocks and underselling the downside. Most advisors applaud price increases! They lead investors to believe that price increases are a pure good and that sticking at the same stock allocation at all times (Buy-and-Hold) can work. Huh?
Most investors believe what they hear from the “experts.” The result is that valuation levels go up and up and up (with small drops mixed in, to be sure) over the course of the bull portion (which can last 20 years or so) of a bull/bear cycle. Then they have to pay back all of the Pretend Gains for the market to be able to continue to function. That’s why we have price crashes. Price crashes translate into a huge loss of consumer buying power. That’s why we have economic crises. And economic crises scare investors away from stocks and cause bear markets to extend almost as long as the bull markets that preceded them.
All of this is horrible for our entire society and all of this is 100 percent optional. If the “experts” would talk about the implications of Shiller’s “revolutionary” (Shiller’s word) findings to their clients and readers, we would never see the bull markets that set all this horror into motion in the first place. The problem is that investment advisors are compromised. The way to sell things is to make people happy with you and telling people that the Pretend Gains from a bull market are real makes them happy. Buy-and-Hold sells. Valuation-Informed Indexing works. But how many “experts” do you see advocating VII over BH in the middle of an out-of-control bull market?
I don’t agree with you about the correction likely being 32 percent. I think you are assuming a return to fair-value price levels. We have seen four bull/bear cycles in the history of the U.S, market. In the first three, the secular bear market did not end until the P/E10 level dropped to 8 or lower. If that pattern holds true this time, we are looking at a price drop of about 65 percent.
And the pattern is not the result of coincidence. That pattern results from the fact that Shiller is right that stock-price changes are not caused by economic developments (as the Buy-and-Holders claim) but by investor emotion (which of course is influenced to some extent by economic developments but not in an entirely rational way). Irrational Exuberance is followed by Irrational Depression because investors treat those bull-market gains as real. They plan their lives around them. When the money they were counting on to fund their retirement plans disappears, they freak out. Prices don’t drop just to fair-value levels but well below that.
The answer once again is to give people accurate, research-based guidance AT ALL TIMES. We have to stop this stuff of pushing Buy-and-Hold strategies during bull markets and then advising everyone to get out of stocks altogether when the bear takes us down to a P/E10 of 8. We should want our markets to be stable. Stability comes from adding a brake to the car. The natural brake is an informed take on valuations. Stocks are a far less attractive asset class when prices are high than they are when prices are low or fair. We need to tell people that. And we need to do so with now hemming or hawing.
It is my take that Shiller is engaging in a good bit of hemming and hawing about his own amazing research because he wants people to like him That undermines the cause. When people see Shiller take a weak position, they think: “Oh, if even Shiller is not all that concerned, maybe this Buy-and-Hold stuff will end up working out after all.” Shiller knows that Buy-and-Hold can never work (or at least he should — I grant that it is possible that he is suffering from a good bit of cognitive dissonance). He needs to say that in clean and firm and unmistakable terms. Or at least so Rob Bennett sincerely believes.
Again, I LOVED your comment. I hope that we will have further opportunities to interact. I have a blog (arichlife.passionsaving.com) where I report on these matters on a daily basis. If you have any interest in writing a blog entry expanding on your criticisms of my approach (in the same fair way that you employed here), I would be thrilled to run that article. It would be a big help to my readers (all three of them!). Anyway, that was good stuff.
My best and warmest wishes to you and yours, Aaron.