I’ve posted Entry #333 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Overvaluation Is “Sticky” Because Investor Emotion Is Sticky.
Juicy Excerpts: The idea at the root of the buy-and-hold strategy is that price changes are determined by unforeseen economic developments. Unforeseen economic developments should not follow any pattern at all. If prices were determined by unforeseen economic developments, today’s P/E10 value would tell us nothing about where prices will land in future days. But just about everyone now acknowledges that the correlation between today’s P/E10 value and long-term returns is robust. We have won the battle over whether P/E10 is telling us something. The fight that remains is in persuading the buy-and-holders that there is a profit to be made by changing one’s stock allocation in response to the signals sent by changing P/E10 values.
The stickiness of P/E10 values argues against the idea that price changes are determined by unforeseen economic developments. In a market in which prices were determined by unforeseen economic developments, valuations would not be sticky; they would change rapidly as new information arrived to influence the decisions of perfectly rational investors. It is emotions that are sticky, not reasoning. The stickiness of valuation levels tells us that prices are determined primarily by shifts in investor emotions, not by unforeseen economic developments.
http://www.philosophicaleconomics.com/2014/06/sixpercent/
For your reading enjoyment. Not that you’ll be able or willing or able to understand the contents thereof.
“Across the full spectrum of time horizons, the correlation just isn’t very strong. That’s because valuations aren’t reliably mean-reverting. There’s too much valuation variability in the historical data set, even when we use “Shillerized” averages over 10 year time spans. For the correlation to get tight, the growth and dividend errors have to superficially cancel with the valuation errors–but that doesn’t consistently happen, hence the breakdown.
Now, to be clear, I’m not saying that valuation doesn’t matter. Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world. Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive. This is true whether we’re talking about individual stocks, or the aggregate market.
What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.
In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be. In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued. The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert. If they did, we wouldn’t be having this discussion.”
Depends on your definition of “robust.”
https://personal.vanguard.com/pdf/s338.pdf
“We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an
inverse or mean-reverting relationship with future stock market returns, although it
has only been meaningful at long horizons and, even then, P/E ratios have “explained”
only about 40% of the time variation in net-of-inflation returns. Our results are similar
whether or not trailing earnings are smoothed or cyclically adjusted (as is done in
Robert Shiller’s popular P/E10 ratio).”
For your reading enjoyment.
I like this passage a lot, Long-Time.
I don’t agree with the conclusions presented. But the author of this passage is dealing with the issues that matter and one doesn’t often see that. So seeing this one makes me happy. Thanks for linking to it.
I am going to add an entry to my list of Future Column Topics raising the idea of writing a response to this one. I am not certain that it will work its way to the top of the list. But there’s a good chance. This article could be used as the Buy-and-Hold contribution to the sort of debate that we should see being held at every investing discussion board and blog on the internet.
Good stuff.
Rob
Depends on your definition of “robust.”
I believe that I have seen this or something similar to this before. So it doesn’t excite me quite as much as the one above. But it gets extra points for being from Vanguard. And it aims at achieving similar goals. It is an argument for Buy-and-Hold that engages with the Shiller research findings rather than ignoring them and that is of course always a plus. As I noted re the other piece, this is the sort of thing that we need to see more of. Again, thanks for the link.
I can imagine writing one column that responds to both of these pieces. That would be a sensible way to proceed. Thanks for creating some new work for me!
Rob
“I don’t agree with the conclusions presented.”
Because “common sense”, right?
It’s amazing that such perception and thoughtful analysis gets ignored.
Common sense should count for something in my view, Anonymous. I certainly am not inclined to dismiss something just because it is in accord with common sense. Valuation-Informed Indexing is 100 percent in accord with common sense. It is also of course 100 percent in accord with the last 36 years of peer-reviewed research, which CONFIRMS that what common sense tells us MUST be so in fact IS so.
I may write a column on this piece. If I do, I’ll spell things out there.
.
The short version is that the article argues that: “valuations aren’t reliably mean-reverting.” It’s not reasonable to expect that they would be. Overvaluation is IRRATIONAL It is the product of investor emotion. When you are dealing with an irrational phenomenon, you should not expect precisely predictable outcomes. And indeed we don’t get them. Stock returns are predictable only in the long run and not precisely so even then. All of this is 100 percent clear from all the research that I have seen. There should be no controversy over any of this.
What this guy is saying is that there is always a range of outcomes. That is so. But the safe withdrawal rate is by definition the worst-case outcome. It is not necessary to predict precisely what outcome will turn up to identify the safe withdrawal rate. You identify the range of outcomes starting from the valuation level that applies on the day the retirement begins and then you identify the highest withdrawal rate that works in the worst-case scenario as the safe withdrawal rate. That’s obviously not the same number at all valuation levels. This guy is saying that the safe withdrawal rate CHANGES with changes in valuation levels.
Rob
“We have won the battle over whether P/E10 is telling us something. ”
There was never a battle here – everyone knows that low interest rates on bonds, or high P/Es on stocks, generally result in lower returns than when interest rates are high (bonds) or P/Es are low (stocks). Sometimes stocks/bonds should be expected to return 11%/7%, sometimes it’s 7%/3% (the ERP is about 4% historically).
But that’s a far, far, far cry from declaring stocks are due for a 60% correction in the next three years.
If everyone knows what you say that everyone knows, then everyone knows that the safe withdrawal rate is not a constant number. The return provided obviously affects the safe withdrawal rate. Financial fraud is a felony.
The reason why those who are familiar with the past 36 years of peer-reviewed research say that there is a strong chance that we will see a 60 percent correction within the next three years is that there has never yet in U.S. history been a secular bear market that ended with a P/E10 of more than 8. That’s more than 60 percent down from where we are today. If you count 10 years from 2009, when prices shot back up to insanely dangerous levels, that’s 2019, within three years from today.
The ten-year thing is a rule of thumb. Stock returns are highly predictable only in the long-term, generally defined as 10 years or more. It could be off by a year or so. For example, Shiller said in his Federal Reserve testimony that those going with high stock allocations at the time (October 1996) would regret it within 10 years. The stock crash did not come until 2008. So he was off by two years. So what? He was a lot closer to the mark than any of the Buy-and-Holders. What he told us was of immense value for dozens of reasons.
We don’t know everything there is to know about how stock investing works today. No one says we do. But we know bunches and bunches and bunches more than the Buy-and-Holders pretend we know. We know that the safe withdrawal rate is a number that varies from 1.6 percent real to 9.0 percent real, not a constant 4.0 percent real. And we know that out-of-control bull markets always lead to economic crises; there has never yet been a single exception in U.S. history. And we know that stock prices are self-regulating so long as investors are permitted access to the information they need to act in their self interest. And we know that the Buy-and-Holders have been working very, very, hard for 15 years now to keep this information out of the hands of the millions of middle-class investors who want and need access to it.
Rob
“there has never yet in U.S. history been a secular bear market that ended with a P/E10 of more than 8”
But markets don’t consult history books when deciding where to move. There’s never been an *infinite* number of scenarios – until they happen.
There are millions of price patterns out there (“Apple stock has never dropped 20% when there’s been a drought in Texas”). But hunting for them and guessing they’ll reoccur is just silly. Markets have no memory.
But markets don’t consult history books when deciding where to move.
I like this comment a lot, Anonymous. I don’t agree with your conclusion. But it is my view that the point that you are making is an important one and a helpful one.
I 100 percent agree with you that markets don’t consult history books. This goes to the mistake that short-term timers make. They look for patterns in the history books and they proceed on the assumption that these patterns are going to repeat. My view (and it is my very strong sense that you agree with me re this) is that these people are fooling themselves. Buy-and-Holders have a great distaste for the search for historical patterns. I generally share this distaste.
I say “generally” because I obviously find some significance in the pattern that I referred to in the comment to which you were responding. I say that we always drop to a P/E10 value of 8 before seeing the end of a secular bear market. If that is so, we are all (including those of us not even in the market) going to see a lot of pain in days to come. But you are of course correct that markets don’t consult history books. So why do I even bother pointing out this pattern? Patterns don’t matter. Why be concerned about it?
The reason why I give a small number of patterns a significance that I do not give to the sorts of patterns cited all the time by short-term timers is that I believe that Shiller did more than just point out a particular pattern (that’s really all he did — he showed that there is a correlation between the P/E10 value that applies today and the stock price that applies 10 years down the road –that correlation creates a return pattern that plays out over time). It’s not the pattern that Shiller pointed out that is so all-important. That pattern is interesting. But the existence of the pattern suggests something far, far more important. The existence of the pattern suggests that the Buy-and-Holders were wrong in their core assumption re how markets work.
The Buy-and-Holders believe that it is economic developments that cause price changes. This is a core belief. If this is not so, everything that the Buy-and-Holders have ever said is called into question. Shiller ripped our understanding of how stock investing works apart. This is why I always note that he called his 1981 research findings “revolutionary.” And this is why he was awarded a Nobel prize. Shiller did not just point to one particular pattern that has always applied. He challenged the fundamental premise of the entire Buy-and-Hold project. If the market is efficient /rational, as the Buy-and-Holders believe, then prices should play out in the pattern of a random walk. Shiller showed that they do not. Shiller showed that the market is not efficient/rational.
If the market is not efficient/rational, then what is it?
Shiller’s answer is that it is emotional. It is investor emotions that set stock prices, not economic developments. That’s why the title of his book is “Irrational Exuberance.” Shiller says (he doesn’t say it directly because he does not not want to be attacked by emotional investors but this logically follows from lots and lots of things that he does state directly) that you cannot trust the numbers on your portfolio statement — they are the product of investor emotion, nothing more, and emotions can change dramatically overnight. To say that you have enough to retire because your portfolio statement sets forth a certain number should give you little confidence because the number reflects cotton-candy nothingness (emotions), nothing more.
That’s not 100 percent true. That’s not quite the entire story. There is another element to this story.
The other element is that the stock market always does reflect the economic realities in the long term. If it was only investor emotion that matters, stock prices would go up and up and up and up and never come down. We would all vote ourselves instant retirements and our scheme would work because the numbers on our portfolio statements would support our scheme. We the investors comprise the market and the market determines what the numbers are on our portfolio statements and the numbers on our portfolio statements determine when we can retire. So we decide when we can retire. We can retire tomorrow if we want to. All we need to do is to persuade all of our investor friends to engage in the same fantasies that we want to engage in. Since the fantasies work to their benefit as well, this is not hard to do. The result is what we call a “bull market.” Except it never works. There is some other force that always causes bull markets to go “pop.”
This other force is common sense. We all have it. We cannot escape it. We all possess a Get Rich Quick urge and that is why we have bull markets. And we all possess common sense and that is why all bull markets end badly. It is the tension between our Get Rich Quick urge and our common sense that determines the numbers on our portfolio statements, not the economic realities. But our common sense longs for the economic realities to apply and so there is indeed a connection between the economic realities and the numbers on our portfolio statements. It is just that that connection applies only in the long term. Prices are always moving in the direction of the economic realities but it takes 10 years or sometimes even a little more than that for them to get there. Overvaluation can remain in place for significant stretches of time. But the economic realities always asset themselves in the end and those who take the numbers that temporarily appear on their portfolio statements too seriously make a very big mistake.
I care about the pattern that I cited because it shows how stock investing really works. I don’t care about the specifics of it because I don’t trust historical patterns any more than you do. But I care deeply about getting the numbers right. And it is not possible to get the numbers right if you ignore this tension between the Get Rich Quick urge that we all possess and the common sense that we also all possess that decides where stock prices are going to end up in the long run.
I want to get the numbers right. I take note of the patterns that I need to take note of to get the numbers right. I don’t take it beyond that. I don’t make precise predictions because I don’t trust historical patterns to tell me what I need to know to get precise predictions correct. But I refuse to ignore historical patterns that reveal to me the basics of how stock investing works in the real world and that warn me never, ever, ever to accept those portfolio statement numbers at face value. I adjust the emotion-rooted numbers to bring them more in line with the economic-reality-rooted numbers that would apply if we investors had better control of the Get Rich Quick urge that for many years now has made stock investing a risky enterprise (but that no longer needs to do so now that we know what the last 36 years of peer-reviewed research in this field teaches us).
Rob
“The Buy-and-Holders believe that it is economic developments that cause price changes. This is a core belief. If this is not so, everything that the Buy-and-Holders have ever said is called into question.”
That’s not a “belief”, that’s reality. If all of a company’s factories burn down, its stock price will decline. That is an absolute certainty.
“If the market is efficient /rational, as the Buy-and-Holders believe, then prices should play out in the pattern of a random walk.”
Let’s talk bonds instead of stocks. Interest rates move randomly, but there are sometimes long periods of higher interest rates, and periods of lower rates. That doesn’t mean anything “emotional” or “irrational” is going on. That simply reflects the economic realities of the period. (Stock P/Es work the same way.)
You can hunt for patterns in these long term trends: “There’s never been a period in US history where interest rates didn’t rise to 9% after falling to 4% for more than 5 years”. But that doesn’t mean the pattern you found will repeat.
If all of a company’s factories burn down, its stock price will decline.
And if a company’s stock is priced at three times fair value and the irrational exuberance that caused the mispricing disappears, the price will decline by a lot more than the amount by which it would decline as a result of all of its factories burning down. The odds of irrational exuberance disappearing are a lot greater than the odds of all of the company’s factories burning down.
Most of the risk of stock investing results from ignoring valuations, not from factories burning down. You can protect yourself from the risk of factories burning down by buying multiple companies. That doesn’t offer protection from the risk of overvaluation at a time when the stocks of most companies are overpriced.
That doesn’t mean anything “emotional” or “irrational” is going on.
Overvaluation is always the result of investor emotion. Rational investors price stocks properly.
that doesn’t mean the pattern you found will repeat.
We have 145 years of stock market history available to us for review. Valuation-Informed Indexing has beat Buy-and-Hold on a risk-adjusted basis for 145 out of those 145 years. Is it possible that it is all going to turn out different this time, that the purely emotional approach is going to beat out the research-based approach for the first time. Anything is possible. But I don’t feel comfortable going with the long-shot bet with my retirement money.
The patterns of history might not repeat. But they might. And, if the do, the Buy-and-Holders won’t be able to get their money back and try a do-over. This is a game where you get one chance at getting it right. I prefer to go with the approach backed by 36 years of peer-reviewed research over the approach that even its fiercest advocates have concluded cannot be defended in civil and reasoned debate.
Rob
“And if a company’s stock is priced at three times fair value ”
The only “fair value” is the market price. Any other “fair value” is just a guess on your part. If gold is selling for $1,300 per oz, you’re welcome to declare: “Based on my analysis, the fair value is $200 per oz”, but that doesn’t make it true.
You can even show 145 years of historical data to back up your claim. The problem is, the market doesn’t care about what happened 145 years, or days, ago.
” 36 years of peer-reviewed research ”
Can you link to any academic research showing there’s an objective, unchanging, “fair value” for stocks? Shiller certainly never mentions such a thing.
Shiller talks about the fair-value P/E10 level all the time. If there were really no fair value, there could be no overvaluation. When you question whether there is such a thing as fair value you are questioning whether there is such a thing as overvaluation.
I disagree with you when you say “the market doesn’t care about what happened 145 years, or days, ago.” The market is us. We care very much. If we didn’t care so much, the P/E10 value wouldn’t be able to predict so effectively how we are going to change prices over the next 10 years. We can see how much you Goons care by the behavior you evidence on all the boards. You care very, very much. And of course all the rest of us do too. And, together, we are the market.
Rob
In September 2015 Shiller said the fair value for the Dow was 11,000. Now, with the Dow over 21,000, he says it could go up another 50%. So as a devoted follower of his every word, where do you put your money, when his words are going every which way?
Obviously Shiller’s Nobel Prize doesn’t mean he can predict the market any better than anyone else. As you have found to your great dismay and financial ruin.
I don’t follow Shiller’s every word. I think he is a giant in this field. But I of course also think that Bogle is a giant in this field. And I don’t think that there is any fair-minded person who would say that re Bogle I am “a devoted follower of his every word.” I take from Bogle what I find valuable and I am grateful for what I have learned from him. And I do the same re Shiller.
Shiller’s Nobel prize does not permit him to engage in short-term market timing any better than anyone else, in my assessment. But it sure do does permit him to engage in long-term market timing far more effectively than Bogle or any of the other Buy-and-Holders. Shiller predicted the economic crisis that began in 2008 in a book published in March 2000. Bogle sure didn’t do that. Shiller was able to do that because his research has taught him important thing about how the stock market works that Bogle has unfortunately not yet integrated into his thinking.
I agree 100 percent with Shiller that the market could go up another 50 percent. All that you need to do to see that this is so is to look at what happened in 1997, 1998 and 1999. In 1996, market prices rose to insanely dangerous levels. I took my money out of stocks in the Summer of 1996 because of those insanely dangerous price levels. And Shiller predicted in Federal Reserve testimony delivered in October 1996 that those sticking with high stock allocations despite those price levels would live to regret it within 10 years. Prices rose over the next three years by a lot more than 50 percent. I don’t see what more could be needed to prove this particular point.
My gripe with Shiller is that he focuses on the wrong point when he makes this accurate claim. Yes, stock prices could go up another 50 percent from the insanely dangerous levels where they stand today. What of it? Those who leave their money in stocks following a 50 percent increase starting from today’s price levels are going to give all that money back when prices return to fair-value levels (or to much lower levels) in the following years. So what real benefit is there in this? When Shiller focuses on this aspect of the question, he is saying words that are going to mislead a lot of people into underestimating the risks of investing heavily in stocks at today’s prices. That’s extremely unfortunate, in my view.
There is nothing wrong with Shiller saying what he said. It is a true comment and it is an important truth that he pointing to. But it is not the entire story. I would make that comment and then I would add the comment that a 50 percent price jump that starts from today’s price levels will not supply any long-term benefit to those sticking with their high stock allocations. That is the point that is poorly understood today (the vast majority of investors already appreciate that prices could go up another 50 percent from today’s levels). Today’s stock investors need to know that they should not be rooting for a 50 percent price increase, that a 50 percent price increase will hurt them in serious ways. That’s the new understanding of how stock investing works that follows from an appreciation of the “revolutionary” (Shiller’s word) research findings of 1981.
As for your comment that Shiller’s words “are going every which way,” I think there is some merit to this complaint. The answer here is to knock off the funny business. There are lots of experts in this field who would be 100 percent happy to share with Buy-and-Holders what the last 36 years of peer-reviewed research tells us all about how stock investing works in the real world. Most people don’t like to be threatened with violence and with career destruction. Rein in your most ugly emotions and you will hear sounder and clearer and more enriching and more helpful investing advice from just about everyone in this field. This extreme (and in some cases even criminal!) behavior affects what you hear from Shiller and lots and lots and lots of others. You are hurting yourself and lots of others in very serious ways when you continue to engage in your insanely abusive behavior.
All of this is my sincere take re these terribly important matters, in any event.
I naturally wish you the best of luck in all your future life endeavors, my good friend.
Rob
All self-proclaimed market timers (short term, long term, any term) have two things in common:
1) They all fail.
2) After they fail, they all say (to anyone left who will listen) “I’m not wrong, I’m just early.”
You knock it out of the park on both of those.
It’s one thing for you to hold that view for yourself. It’s something very different for you to hurt millions of other investors who would like to hear the other side of the story by denying them access to it through your abusive posting.
I will tell those millions of other investors the story of what was done to them in the days following the next price crash and we will take it from there.
I wish you all good things.
Rob
“millions of other investors who would like to hear the other side of the story”
The other side being that there are successful market timers? Where are they? Bogle says he knows of no one. And he knows everybody. If just one guy would take him on and PROVE his results, he’d be so rich and famous that your $500 million would be a week’s pay.
Too bad he doesn’t exist. Not even in your imaginary world.
Bogle is every bit as capable as I am of becoming familiar with the last 36 years of peer-reviewed research in this field and of thinking through what it means about how stock investing works in the real world, Anonymous.
I think he would pass a lie detector test if you asked him “Do you believe that market timing works?”
But I don’t believe that he would pass a lie detector test if you asked a”Is there any circumstance in which death threats or threats of career destruction are appropriate in discussions of stock investing?” and he answered “yes.”
We will have to decide as a society how to come to terms with that. I intend to praise my good friend Jack to the skies re his genuine contributions and to make every argument that I can think of to place him in the best possible light in the eyes of millions of middle-class investors. But I have zero willingness to go to the wrong side of the Felony Line myself. I will never say that Greaney’s retirement study (or any other Buy-and-Hold retirement study for that matter) contains an adjustment for the valuation level that applies on the day the retirement begins. And I will never deny that there is 36 years of peer-reviewed research showing that valuations affect long-term returns.
We will just have to wait to see how it all plays out.
I naturally wish you (and my good friend Jack Bogle!) the best of luck in all your future life endeavors.
Please take good care, my old friend.
Rob
“In September 2015 Shiller said the fair value for the Dow was 11,000. Now, with the Dow over 21,000, he says it could go up another 50%. So as a devoted follower of his every word, where do you put your money, when his words are going every which way?”
Exactly. Shiller has no immutable concept of “fair value” for interest rates or P/Es. He just gives wildly differing guesses at different times.
Again, there’s no academic research proving any concept of “fair value”. Sometimes demand for capital is low (low interest rates, high P/Es), sometimes it’s high (high rates, low P/Es). This demand changes based on unpredictable economic events.
And that’s why making a claim like “Stocks will drop 60% in three years” will probably result in embarrassment. You might get lucky, if unforeseen events cause such a thing. But you can’t know that ahead of time.
We will have to wait to see how it all plays out, Anonymous.
I naturally wish you all the best of luck with it in any event, my good friend.
Rob